Passing Wealth, Not Tax Bills

The Great Wealth Transfer has commenced, and tens of trillions of dollars are set to be transferred between generations over the next two decades. However, for some heirs it feels more like a burden than an inheritance. Proper asset location can help lift that burden while maximizing your legacy.

What is Asset Location?

Asset location refers to the strategy of pairing investments with proper account types to ensure maximum tax efficiency. For example, Roth IRAs are powerful due to their potential for tax-free growth. Given this, Roth IRAs should be more heavily invested in equities in order to maximize tax-free growth.

While there isn’t anything that says you can’t place fixed income investments in a Roth IRA, it isn’t very efficient and you would likely be better suited using a pre-tax IRA or brokerage account for your fixed income allocation. According to a study conducted by Charles Schwab in 2024, asset location can boost after-tax returns by up to 0.41%. Ideally, this additional return compounds to where you may have substantially more in assets at your death than you would have had if you placed assets inefficiently.

How Does This Impact Estate Planning?

While the conversation surrounding asset location starts with investments, it can also have huge estate planning implications, specifically for those leaving assets to children in different economic situations. Generally speaking, an heir in a lower tax bracket can benefit from inheriting a pre-tax retirement account more than an heir in a higher tax bracket would.

For example, let’s say John Doe passes leaving a $1 million pre-tax IRA and a $1 million Roth IRA to his two children, Jane and Joe Doe, in equal shares. Jane Doe is a physician who regularly lands in the 35% or higher tax bracket and Joe is a teacher who lands in the 12% tax bracket.

In accordance with the Secure Act, these inherited accounts must be spent entirely within ten years of inheriting. Assuming no growth, Jane and Joe would each need to withdraw $50,000 annually from the pre-tax bucket. With Joe landing in the 12% bracket, the most he will have to pay in taxes on that withdrawal is 22% (ignoring other income sources). However, Jane is already in the 35% tax bracket before her withdrawal, so she will be paying at least that amount in taxes with the possibility to jump to the 37% bracket. Because of the tax implications, Joe will receive an additional $6,500 annually after-tax than Jane. So how can we balance this?

We’ve been focused on the pre-tax IRA in this example but don’t forget about the $1 million Roth IRA that John Doe so graciously left behind for his children. To increase the efficiency of his estate, John might consider adjusting the beneficiary designations across his accounts to leave his pre-tax assets to Joe and his Roth assets to Jane. Joe gets to take advantage of filling up lower tax brackets while Jane avoids the headache of increasing a tax bill that she already likely feels is too high.

Transparency Matters

As you may have gathered, proper asset location and the impact on estate planning requires having some understanding of the financial circumstances of your heirs. For some, this can be a difficult conversation to navigate as people generally are very protective with whom they share the details of their financial life.

Being proactive about this conversation and explaining the rationale can be helpful with getting people to open up. You don’t need to go monitoring your heirs bank accounts and spending habits, but having an idea of where they can reasonably expect to land on the tax brackets can be extremely valuable information to have for estate planning purposes.

Summary

In conclusion, proper asset location starts with investments, but the implications are far reaching. Having an understanding of the impact of asset location on your investments and the subsequent impact it has on your estate plan can help individuals to maximize the legacy they leave without adding additional complications to the inheritor’s situations.

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