Thank Your Parents for that Tax Bill

I often joke that the reason parents exist is to give their children things to talk to a therapist about. As many of us will find out in the coming years, another reason is to give their children tax bills to be agitated about.  Your parents might not actually be engaged in a conspiracy to bloat your tax bill (conspiracies aren’t all that common despite the amount of mania about them these days…), but they could be getting ready to weigh down your Form 1040 just the same.

The Great Wealth Transfer

Baby Boomers are retiring in droves and many practiced admirable frugality over their lifetimes. The semi-tax-savvy among them socked away lots of dollars in their 401(k)s and IRAs.  That pesky compounding formula combined with your parents’ aversion to spending, combined with their aversion to paying taxes means… they may die with a really big 401(k)/TSP/403(b) and or IRA balance.

Hopefully they practice good beneficiary hygiene and they like you, so you’re going to inherit that money when they pass away. Sort of.

It’s More of an IOU than an IRA

For many reasons, Boomers are more likely to have their 401(k) and IRA in Traditional (pre-tax) accounts than Roth accounts. Remember that with Roth accounts, we pay the tax bill on the dollars in the year we earn them. But with Traditional accounts we pay the tax bill when the money comes out of the account.

Thus, a Traditional IRA or 401(k) has a silent partner named Uncle Sam that intends to get a slice of every dollar that comes out of the account whether that dollar goes to your parents or to you. These accounts are a balance and an IOU to Uncle Sam and death doesn’t change that fact.  We see them as assets, the IRS sees them as income.

When you inherit your parents’ Traditional accounts, the legacy of that tax bill continues. They left you money, which is a superb first world problem, but they probably left you more of a tax bill than they had to, which could be a generational tip for the taxman.

Perfect World Tax Planning

I’m big fan of things that don’t exist such as magical gift-giving elves with high BMIs and an informed electorate that treats governance as a serious matter rather than a reality-TV bloodsport, so it’s no surprise that I like to daydream about how family tax planning happens in a perfect world. I’m sure you feel the same way, so let’s examine that perfect world.

Features of the perfect tax planning world would include:

1. Your parents communicate their plans with you and ask for input.
2. Your parents focus their wealth on maximizing lifetime fulfillment rather than dying with untapped wealth that could have benefited their heirs decades earlier.
3. You have candid conversations with your parents, probably with a tax-focused fiduciary planner in the room, about the whole family’s tax situation over the not just the current years, but at least each lifespan.
4. Your siblings do the same.
5. Your parents optimize the use of their dollars to maximize their fulfillment and suppress:
   1. Their lifetime tax bill
   2. Their heirs’ lifetime tax bills
6. All of this happens while your parents are young enough to still grasp the financial intricacies and technical details. (Many won’t have capacity or interest in changes in their later years.)

Possible outcomes of “Perfect World Tax Planning” could include:

1. Your parents perform Roth Conversions each year after prioritizing for either:
   1. 2 Spouses alive over a similar period of years using Married Filing Joint tax status.
   2. 1 Spouse reporting about the same amount of income but paying tax at the higher Single rates. Or.,
2. 0 Spouses such that the Roth Conversions suppress the heirs’ tax bill.
3. You inherit mainly Roth dollars rather than pre-tax dollars.
4. Your parents may leave you taxable assets that get a step-up in basis (potentially $0 tax bill) rather than a large pre-tax balance.
5. You offer to pay for Roth Conversions for your parents and they accept knowing that it will lower your tax bill. (Sometimes called reverse or upstream gifting…)
6. You don’t climb the tax brackets like Michael Scott doing parkour in your peak earning years. More on this below.

Okay, since Perfect World Tax Planning probably isn’t a thing for most of us, let’s look at the math of “Messy Family Dynamics Tax Planning World” which is probably what we all live in and so we’ll just shorten that to “Normal World Tax Planning.”

Normal World Tax Planning

In the normal world, we still have gift giving entities with high BMIs, but they lack magic and elfin heritage. We definitely have problems with the electorate. As far as tax planning, you already know how your family behaves and what Boomers are likely to do. So possible outcomes in the normal world include:

1. Your parents don’t talk about money. You assume they won’t.
2. Your parents have told you that the money stuff is fine. You assume it is.
3. Your parents have “a financial guy.” You hope he isn’t loading them up with inappropriate annuities or otherwise playing the roll of vampire squid on your potential inheritance.
4. Your parents’ financial guy is pretty old school. When they ask him about tax planning, he shuffles his feet and mumbles something about, “you’ll have to ask your tax advisor.” They shrug thinking, the tax preparer doesn’t really give advice…
5. Your parents don’t know your financial situation beyond whether or not they need to give you financial outpatient support to keep you out of their basement. They assume you probably don’t want to talk about it.
6. Your parents may have a Will, but they’ll be gifting you Probate which is a synonym for: months-to-years of estate settling activity during which attorneys receive a wealth transfer. You don’t ask what their plans are.
7. Your parents have heard about Roth Conversions, but feel confused. You don’t know they’re even considering the topic.
8. Your parents fret about running out of money every day of their life, yet they don’t spend a fraction of their wealth which is compounding away. You assume this is the way and probably act the same at their age.
9. Your parents lose interest and cognitive ability to tackle more complicated financial topics. Your prioritize their care and time with them knowing that the money stuff will have to get sorted out later.
10. You inherit what they couldn’t spend. You’re in your peak earnings years. The mandatory distributions add 25%-50% to your annual tax bill. The government spends their needlessly chunky slide of the inherited dollars on your least favorite program while you seethe.

You get the picture.

Cleared to Rejoin

The potential to inherit our parents is a wonderful first-world problem and we hope they’ll just spend it on their fulfillment and care because we read financial blogs from a washed up fighter pilot and know we’re going to be financially squared away.  We may never get to the perfect world where open, transparent, generationally-focused tax planning permeates the family, but even a little progress can keep dollars in the family and away from the IRS.

Thanksgiving is coming up. Perhaps start practicing your icebreaker: “Hey Mom and Dad, my friend Robin told me that he and his wife Ella are paying for their parents to do Roth Conversions. Have you ever heard of something like that?” (results may vary…)

Fight’s On!

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