The two biggest assets most people have are their home and retirement accounts. Unfortunately, this often means that poor (or no) estate and financial planning can lead to the government being your main beneficiary, and your children end up just getting the leftovers. When people fail to optimize their estate and financial planning choices, they lose the opportunity to minimize, or even cut out completely, what the government gets from their estate. All too often, it’s duct tape solutions or an attitude of  “crossing the bridge when we get there” that causes estates to hemorrhage money directly to the IRS and state departments of revenue. Here are two examples of John Doe’s duct tape planning and his four children being his beneficiaries… after the government gets the largest cut, that is.

John Doe’s Assets

  • Home purchased for $100,000 more than 20 years ago, now valued at $500,000, and which he re-deeded in his and his four children’s names as joint with a right of survivorship to avoid probate
  • An IRA worth $1,000,000 and a spousal rollover IRA from his deceased wife, also worth $1,000,000, and both name his four children as pay-on-death beneficiaries

Retirement Accounts:

John’s two retirement accounts are the major part of his estate, and he has done everything he could to avoid taking money out because every dollar that comes out is taxed, and he thinks 24% is just too much to pay if he doesn’t have to. All four of John’s children are successful, just reaching into the top tax bracket of 37%. John dies, and now his children inherit his IRA. The four children now get $500,000 each, but at the 37% tax rate (since it goes on top of their annual income), now they each only receive $315,000 after paying the $185,000 in taxes. So let’s recap who the beneficiaries of John’s IRAs really are:

  • Child 1: $315,000 15.75%
  • Child 2: $315,000 15.75%
  • Child 3: $315,000 15.75%
  • Child 4: $315,000 15.75%
  • Federal Government: $740,000 37%

All of this also ignores state-level income taxes, which would make things even worse. [Yes, the income can actually be spread out over ten years, but withIs the Government Your Main Beneficiary the four children all being in the top tax bracket anyway, it doesn’t end up changing the proportions.] With these numbers, John can do some proactive planning to reduce the overall tax burden for the family through bigger annual withdrawals and reinvestment, and even possibly Roth conversions to allow the money to grow tax free. A specific financial strategy can be developed and followed to reduce the tax impact as much as possible, but unfortunately most people just stick with the minimum distributions each year.

The House: John also wants his children to inherit his home and then sell it for the proceeds once he passes on, and at the same time he doesn’t want the house to go through probate so he retitled the house as joint with a right of survivorship with his four children. John’s house was purchased at $100,000 but is worth $500,000 when he retitled the house, and it is still worth $500,000 when John dies. The kids go to sell the house, and they end up shocked at the taxes. Because they are all in the top income bracket for capital gains taxes, they have to pay the 20% rate.

Cost Basis FMV of Interest Taxes Due (20%) End Inheritance
Child 1 $20,000 $100,000 $16,000 $84,000
Child 2 $20,000 $100,000 $16,000 $84,000
Child 3 $20,000 $100,000 $16,000 $84,000
Child 4 $20,000 $100,000 $16,000 $84,000
John Doe $100,000 $100,000 $0 N/A
U.S. Govt. $64,000

In the end, the federal government got $64,000 in capital gains taxes out of the children. What could John have done instead? If John wanted to avoid probate, he could have set up a revocable living trust and had his house in the trust, and there would have been ZERO capital gains taxes when the trustee sold the house.

In the end, the two most valuable assets John Doe had were his house and retirement accounts totaling $2,500,000. However, the federal government got $804,000, and each of John’s children only got $399,000. Each child inherited less than half of what the government got, making the federal government John’s largest beneficiary. I’m sure that’s not what John wanted, but he could have planned better to leave much more to his children. Let us know if you want to talk through your specific situation and see how much of a beneficiary the federal government is compared to your loved ones.