Summary/TL;DR
All retirement accounts will be subject to the so-called 10-Year Rule, which requires any non-spousal beneficiary to withdraw the entire account over a 10-year period. If the assets that are inherited are in a pre-tax account, taxes will be owed on every dollar withdrawn, which can result in a significant amount of your legacy being inherited by the government. Taxable brokerage accounts receive a “step-up” in their cost basis when they are inherited, meaning beneficiaries will only owe taxes on any growth that occurs after your death. Finally, the dreaded “estate tax”, while paid by only very few, can be devastating if it’s not properly accounted for. Proper planning can save your estate and your beneficiaries hundreds of thousands of dollars in taxes.
Introduction
Planning for the passing of your assets to your beneficiaries in an orderly fashion is an essential part of any comprehensive financial plan. Closely related to this is the issue of taxation of these assets. No one wants to work their whole life and have one third (or more!) of their wealth be inherited by the government instead of their heirs. The difference between a highly taxed inheritance and a tax-efficient inheritance begins with an understanding of how the different types of investment accounts are taxed. From there, planning and optimization can begin to make a tremendous impact.
Pre-Tax (Traditional) Accounts
After the passing of the SECURE Act in 2019, non-spousal beneficiaries of retirement accounts (401k, IRA, 403b, etc) are required to distribute the entire account over a 10-year period. In the case of pre-tax accounts, they will owe taxes on every dollar that is distributed to them, meaning that a large amount of your legacy could end up funding gender studies in Pakistan without good planning.
Consider the following example – your child inherits an IRA worth $1,000,000 from you and distributes $125,000 per year for the first 9 years and distributes the remaining balance in the 10th year. Your child is also already in the 32% tax bracket (soon to return to 35%), so any distributions that they are forced to take will be taxed at this rate. Furthermore, think about the age that your children will be when they are most likely to inherit their accounts. Many will be at the peak of their careers, earning the most money they ever will in their lives and, consequently, being taxed at the highest rates that they ever will.
As can be seen in the table above, this would result in over $450,000 of your children and grandchildren’s inheritance – your legacy – going to the government instead of to them! They wouldn’t have even received the full $1,000,000 account that you left on an after-tax basis!
The 10-Year Rule is yet another example of why Roth accounts and Roth conversions have become a serious strategy to consider.
Roth Accounts
As retirement accounts, any accounts that carry the Roth designation will also be subject to the 10-Year Rule. The key difference, however, is that beneficiaries will pay no taxes on their inheritance from Roth accounts! Furthermore, your beneficiaries won’t have to take nearly as much out of the account to receive the same net income, meaning more will be retained in the account to grow over the course of the 10-Year Rule. Look at the table below to see how this impacts your legacy.
As can be seen above, this would have left your heirs with over $600,000 more than if they had inherited pre-tax assets.
If you haven’t saved into Roth accounts over your lifetime and don’t have any Roth accounts now, don’t worry! There’s still plenty of opportunity to get pre-tax assets converted into Roth without blowing up your tax bill now. All it takes is a proactive and knowledgeable financial planner familiar with the law and tax code to get your ship back on course!
Brokerage Accounts and Other Assets
For the most part, any asset that is not held within a retirement account will receive a step-up in cost basis at the time of your death. For example, if you bought Apple stock for $10,000 and it grew to $100,000 by the time you died, your beneficiaries would not only owe no taxes on the stock at your time of death, but they would only owe taxes on growth beyond $100,000! The $90,000 in growth that they inherited is received completely tax free.
The same is true for real estate and other non-investment related assets inherited outside of a retirement account.
The Estate Tax
Not a week goes by where I don’t get a question about the dreaded estate tax, often referred to as the “inheritance tax”. Fortunately for most who ask this question, it’s not something they will need to worry about. Currently, no one will pay estate taxes unless they die with a taxable estate over $13M (this is doubled for married couples). In 2026, this “estate tax exclusion” amount will be cut approximately in half, but this still won’t be an issue for most people.
For those who do have a taxable estate over the exclusion, they will pay what essentially amounts to a 40% tax on any amount above the exclusion. Clearly, these are circumstances which necessitate good planning to avoid.
Conclusion
Regardless of your circumstances, your legacy can either be trampled on by taxes or passed along to your beneficiaries in the fashion you desire. The difference, in almost every case, is between good planning and no planning. Being proactive about asset location, tax planning, and estate planning while you’re alive can save your beneficiaries hundreds of thousands of dollars in taxes, thereby extending your legacy as well.