When it comes to building wealth, qualified accounts like IRAs, 401(k)s, and defined contribution plans are often the go-to vehicles. They offer tax deferral, potential growth, and, in some cases, tax deductions on contributions. But while they’re great for accumulation during your lifetime, they can become a tax trap for your heirs if you’re in an estate tax situation.
Let’s break down why:
Double Taxation: The Silent Wealth Killer
Here’s the brutal math: If your estate is over the federal estate tax exemption ($13.61M per person in 2024), qualified account balances are fully included in your taxable estate. That means when you pass, your heirs could face a 40% estate tax hit on the account value.
But it doesn’t stop there.
Your beneficiaries will also owe income tax when they withdraw the funds. Depending on their tax bracket, this could be another 37% (or higher, depending on state taxes). That’s a potential combined tax rate of 60-70% on your retirement account.
For example:
- You pass with a $5M IRA.
- Estate tax: 40% x $5M = $2M owed.
- Remaining $3M goes to heirs.
- Income tax on $3M (at 37%): ~$1.1M.
- Net inheritance: ~$1.9M from $5M.
Ouch.
No Step-Up in Basis: Your Heirs Get No Relief
Unlike taxable investment accounts, which receive a step-up in basis at death, qualified accounts offer no such benefit. That means your heirs inherit your IRA or 401(k) at its full value, fully taxable when withdrawn. No resetting of the tax clock, no opportunity to reduce gains, and no strategic harvesting of tax losses.
The 10-Year Rule: Accelerated Payouts, Less Control
The SECURE Act changed the game. Most non-spouse beneficiaries must now liquidate inherited IRAs within 10 years of your death. This compressed withdrawal schedule often pushes heirs into higher tax brackets, accelerating the tax burden and eroding the account’s value even further.
Qualified Accounts Limit Your Legacy Planning Options
When you’re dealing with estate taxes, flexibility is key. With taxable accounts, you can gift appreciated assets, fund charitable vehicles like Donor-Advised Funds or Charitable Remainder Trusts, or create wealth transfer structures like Grantor Retained Annuity Trusts (GRATs).
With qualified accounts? Your options are severely limited. Most advanced legacy strategies are either off the table or significantly less effective.
So, What Should You Do?
If you’re a high-net-worth individual or business owner staring down a potential estate tax bill, here are a few key strategies to consider:
- Roth Conversions: Pay taxes now at known rates, and pass on income tax-free Roth assets.
- Strategic Drawdowns: Spend qualified assets during your lifetime and leave other, more tax-efficient assets to heirs.
- Charitable Giving: Use Qualified Charitable Distributions (QCDs) or name charities as IRA beneficiaries. Must be 70.5+ and there are annual limits
- Legacy Planning Now: Work with a financial advisor, estate attorney, and CPA to design a coordinated strategy that reduces your taxable estate and maximizes your family’s long-term wealth.
Final Thoughts
Qualified accounts are a powerful tool for retirement savings—but they’re often a terrible vehicle for wealth transfer in an estate tax situation. Without proper planning, your family could lose the majority of these assets to taxes.
If you’re concerned about the legacy impact of your qualified accounts, let’s talk. Together, we can design a plan that minimizes taxes and maximizes what you leave behind.
