Preparing your clients for the Great Wealth Transfer

01/23/2024 — Key takeaways:

• The Great Wealth Transfer is the unprecedented intergenerational shift of assets from Baby Boomers and the Silent Generation to their heirs in the coming years.
• This event could bring beneficiaries of this wealth into your practice where you can build new relationships while retaining assets from previous clients.
• Estate planning and thinking through the tax implications will play an important role in advising clients through this transfer of wealth.

In the coming years, an extraordinary amount of wealth will transfer from Baby Boomers and the Silent Generation to their beneficiaries. According to a report, adults born before 1960 will pass over $84 trillion dollars to their heirs by 2045.¹ This transfer represents both an opportunity and a risk for financial professionals. Many affluent investors do not work with the same financial professional as their parents. This suggests that true multigenerational planning is not as prevalent as you might think. The Great Wealth Transfer could result in many financial professionals losing assets under management as beneficiaries look elsewhere for advice.

You can bring tremendous value to your clients and beneficiaries by helping them prepare for an efficient transfer of wealth to the next generation. This planning can also create important opportunities for you to bring beneficiaries into the process, building relationships and retaining assets under management. Let’s consider a few ways you can prepare your clients and their beneficiaries for the Great Wealth Transfer.

Make sure the estate plan is up to date

Every client should have basic estate planning documents in place, and legacy and estate planning is an important part of anyone’s financial journey. A will is a simple way for clients to take control over who gets what, while avoiding state intestacy rules. Many clients will also benefit from trust planning. Trusts can help avoid probate (a court supervised distribution of assets) and can be very helpful in controlling how assets pass to beneficiaries over time. As a financial professional, you should be prepared to spot life situations where trusts can be particularly helpful, such as second marriages, beneficiaries with special needs, or heirs who simply shouldn’t inherit too much money all at once. Financial professionals should be aware, however, that trust planning can involve important income tax issues, which we’ll discuss in a moment.

Another issue to be aware of is the potential sunsetting of the Tax Cuts and Jobs Act (TCJA) at the end of 2025. Under current law, relatively few clients have a federal estate tax issue, as the estate tax exemption amount is over $12,000,000 per person. If the TCJA expires, however, that exemption would be cut roughly in half, exposing many more clients to possible federal estate taxes. You should also be aware of whether your state imposes an estate tax (ME, VT, MA, CT, RI, DC, IL, MN, WA, OR, and HI), an inheritance tax (NJ, PA, KY, IA, and NE), or both (MD). Keep in mind that these state level taxes can kick in at much lower thresholds of wealth.  The bottom line is that going forward, more clients may need to implement estate tax avoidance strategies.

Having a referral relationship with one or more local attorneys can be critical to this aspect of the wealth transfer process.  It’s important to remember that while a financial professional can identify issues to be addressed, clients will need legal assistance in drafting documents and putting the estate plan in place. A good attorney can also help clients with documents such as powers of attorney and advance health care directives that can be extremely important in the event the client becomes incapacitated.

Stay current with beneficiary designations

For many clients, beneficiary designations on financial accounts will control the transfer of much of their wealth.  Retirement accounts, annuities, and life insurance will all pay out to the beneficiary on file with the custodian of the asset, regardless of any other estate planning they’ve done. It’s therefore critically important for clients to regularly check those designations for accuracy, especially after big life events like births, deaths, marriages, and divorces. An overlooked mistake on a beneficiary designation can have massive implications in a client’s overall wealth transfer plans.

Even simple rules such a "per capita" beneficiary designation can lead to unintended consequences. Under "per capita" rules (which are the default for most custodians), retirement assets are payable to all surviving primary beneficiaries. If a primary beneficiary dies before the account owner, their share will typically be split between the remaining primary beneficiaries. But what if the owner wanted that beneficiary’s share to go to the beneficiary’s heirs? A per stirpes beneficiary designation can accomplish this, but it must be specifically requested, and some financial professionals neglect to discuss this option with clients.

Another aspect to be mindful of when reviewing beneficiary designations is using a trust as a beneficiary of retirement assets. Prior to the Secure Act, trusts could be set up to take advantage to life expectancy distribution rules to distribute assets from the retirement account to the trust over the shortest life expectancy among the trust beneficiaries. With that option now eliminated for most beneficiaries, retirement assets may have to pay into the trust within the 10 years after the owner’s death. This is where knowledge of trust tax rules is very important.  Given that retirement plan distributions are considered ordinary income, and trusts face much higher tax rates at lower levels of income than individuals (for 2024, trusts get to the top marginal bracket of 37% at just $15,200 of taxable income,) a poorly drafted trust can result in significant value being lost to taxes. If you see a trust named as a beneficiary of a retirement account, it’s a good idea for the client to review the trust with the attorney who drafted it to make sure the strategy will still work as intended and not result in unintended tax issues.

Think about the tax implications of different account types

When it comes to the assets you manage, always be mindful of the tax implications of different account types.  For most clients, the biggest tax issue they face relative to wealth transfer won’t be estate taxes—it’ll income taxes.  Many clients will have a combination of taxable, tax deferred, and hopefully some tax-free accounts that will pass to beneficiaries. Some of these accounts will pass to heirs more tax efficiently than others.

Tax deferred assets, which will often make up the bulk of a client’s retirement savings, can be problematic for wealth transfer because they are subject to income taxes. This issue has been exacerbated by the Secure Act, which eliminated life expectancy distributions (the so called "stretch" option) for most non-spouse beneficiaries. Accordingly, many adult children inheriting tax deferred retirement assets will have to withdraw those assets and recognize them for income tax purposes by the end of the 10th full year following the owner’s death. If the owner died after their Required Beginning Date for Required Minimum Distributions, the beneficiary will also have to take their own Required Minimum Distributions in each of those 10 years. For beneficiaries who’re still working, the risk is having distributions taxed at their highest marginal tax rate. In situations where this seems likely, helping parents build a tax-free inheritance by performing Roth conversions at their lower retirement tax rate can be preferable to having a beneficiary pay taxes on distributions at their potentially higher "working" tax rate.

While also considered tax deferred investments, non-qualified annuities offer somewhat better wealth transfer attributes. A non-spouse beneficiary inheriting a non-qualified annuity may still "stretch" the inherited annuity by using life expectancy distributions. Further, non-qualified annuities are funded with after tax contributions. As a result, the investment in the contract (cost basis) can be distributed with no income tax liability to the beneficiary (but only after taxable gains have been fully distributed). A beneficiary of a non-qualified annuity can also select an annuitized payout and receive "exclusion ratio" tax treatment, in which each payment is a pro rata mix of investment in the contract and taxable gains.

Some assets, such as real estate and investments held in non-qualified brokerage accounts will receive a step up in cost basis when the owner dies. These assets offer beneficiaries a potentially huge tax break by essentially wiping out capital gains tax liability at the owner’s death. Assets that will receive a step up in cost basis should be earmarked for wealth transfer whenever possible.

When a client’s beneficiaries are likely to have significant income of their own, it can make sense to leave those beneficiaries income tax free assets rather than tax deferred assets. For example, Roth accounts are tax free to beneficiaries. While these accounts are generally subject to the same distribution rules as tax deferred accounts, their tax-free status gives beneficiaries far more flexibility. For example, a non-spouse beneficiary of a Roth account could choose not to take any distributions for the first nine years after death, and fully liquidate the account in the 10th year with no adverse income tax impact.² That’s an additional 10 years of tax-free growth in the account. This is one reason why many financial planners will counsel clients that Roth assets should be the last assets they should spend in retirement. Finally, don’t overlook the power of life insurance as a wealth transfer tool. A life insurance death benefit passes income tax free to beneficiaries. Maintaining permanent life insurance into retirement, even if you use distributions from tax deferred retirement accounts to pay premiums, can be a tax efficient way to build an income tax free inheritance for beneficiaries.

Become an expert in income tax planning for beneficiaries

If your goal is to be on the receiving end of some of that $84 trillion in transferred wealth, then one key is to become an expert in income tax planning for beneficiaries. IRS Publication 590-B provides the rules that apply for inherited IRA assets and is an invaluable resource when working with people inheriting retirement assets. Let’s say you’re working with a beneficiary of their parent’s retirement accounts. Here are just a few of the things you would want to consider:

• Current tax status: Income, marital status, and tax bracket
• Retirement goals: When does the beneficiary plan on retiring and how much longer will they be earning income?
• Retirement savings: Does the beneficiary have significant retirement savings and when will their RMDs begin?

Here’s a quick example of how planning might work. Diane is a client who is inheriting a $1,000,000 IRA from her mom. She is 60 years old and plans to work until 65. She and her spouse have taxable income from work of $250,000/yr, putting them in a 24% tax bracket.

The good news is that Diane has some flexibility. While she must fully distribute the inherited IRA by the end of the 10th year following her mom’s death, she only has to take a Required Minimum Distribution based on her life expectancy in any given year (we’re assuming mom died after her Required Beginning Date). In the year following her mom’s death, Diane will have to take a small RMD of about 3.9% of the account value.³ Unfortunately, that RMD will be added to their income and taxed at their top 24% marginal bracket. Still, by taking only RMDs while they are working and then taking larger distributions of the balance in the years after they stop working, Diane and her spouse could pay a much lower effective tax rate on those distributions.

Even if Diane were a little older when she inherited the account, she would also benefit from the fact that under Secure Act 2.0, she won’t have to begin RMDs from her own retirement accounts until she turns 75. This delay in RMDs under the Secure Act 2.0 is creates an important opportunity. Not only does it allow beneficiaries to draw down inherited retirement assets tax efficiently before RMDs begin, but it also expands the window of time in which retirees can perform Roth conversions at lower tax rates. RMDs cannot be used for Roth conversions. Accordingly, once RMDs begin, Roth conversions will typically be taxed at higher rates.

How can financial professionals prosper from the Great Wealth Transfer?

The secret to success in the Great Wealth Transfer is working with the heirs who be receiving the assets. For younger clients (and anyone with parents who are still living counts as young), always be sure to discuss and plan for any anticipated inheritance. For older clients, the opportunity is to get introductions to their potential beneficiaries. Talk to those beneficiaries about the potential tax issues they will face, show them how your planning will benefit them, and highlight your expertise in helping them minimize taxes on the assets they inherit. True multigenerational planning will help you protect and grow your practice during the Great Wealth Transfer. For further assistance, you can reach out to your Nationwide partner or the Advanced Consulting Group with questions about IRA and annuity distribution planning.