The Best Investment Account for Leaving a Legacy May Not Be the One You Think
One of the conversations I have with clients as they get closer to retirement is surprisingly simple:
"What do you want your money to do after you're gone?"
Sometimes the answer is straightforward. They want to leave something to their children. Maybe they want to help grandchildren pay for college, leave money to a charity, or simply make sure the next generation has a financial head start.
But once we start talking about how to leave that money, things get more complicated.
One of the most overlooked parts of legacy planning is the type of investment account you're using to hold the money.
Two accounts might each have $500,000 invested in the same portfolio, but the amount your heirs ultimately receive—and the tax bill they face—can be dramatically different.
That's why when I'm helping a client think about their legacy, I don't just ask, "How much do you want to leave?"
I also ask:
"What kind of account are you leaving it in?"
Not All $1 Million Is Created Equal
Let's say you have three different accounts, each worth $1 million:
A traditional IRA
A Roth IRA
A taxable investment account
At first glance, they're all worth $1 million.
But from an estate-planning perspective, they can be very different assets.
That's because the tax treatment doesn't necessarily end when you die.
For example, money in a traditional IRA may still be subject to income tax when your beneficiaries withdraw it. Depending on the beneficiary and circumstances, inherited retirement accounts can also be subject to distribution rules that require the account to be distributed over a specified period.
A Roth IRA can be a very different story. Qualified Roth distributions are generally tax-free, and Roth accounts can be particularly attractive assets to leave to heirs because the beneficiary may receive the account without the same income-tax burden associated with a traditional IRA.
Then there's the taxable investment account.
Taxable investments can have their own advantages in estate planning because of the potential for a step-up in cost basis at death.
That can make a taxable investment account surprisingly attractive for legacy purposes.
And this is where things get interesting.
The Account You Spend First May Not Be the Account You Leave Behind
When you're retired, it's natural to think:
"I'll spend my IRA first because that's the money I have to take out anyway."
But that isn't always the best strategy if you have a legacy goal.
If your objective is to maximize what your heirs receive, the tax characteristics of each account matter.
For example, imagine you have:
$1 million in a traditional IRA
$500,000 in a Roth IRA
$500,000 in a taxable brokerage account
You don't necessarily want to think of those as simply $2 million of investments.
You want to think about them as three different types of assets with three different tax characteristics.
Your traditional IRA may be one of the least attractive assets to leave to your children because future withdrawals may be taxable to them.
Your Roth IRA may be one of the most attractive.
And your taxable investment account may have significant estate-planning advantages depending on the investments, cost basis and applicable estate-tax rules.
So sometimes the question isn't simply:
"Which account should I withdraw from?"
It becomes:
"Which account should I preserve for my heirs?"
That's a very different question.
Why Roth Accounts Can Be Powerful Legacy Assets
Roth accounts are often discussed in the context of retirement income.
But I think they're equally interesting from a legacy-planning perspective.
If you don't need to spend your Roth assets during retirement, you may be able to preserve them for your heirs.
That's potentially valuable because qualified Roth distributions are generally tax-free.
There are still rules that beneficiaries need to follow when they inherit a Roth IRA, so "tax-free" doesn't mean "no rules."
But compared with inheriting a large traditional IRA, a Roth can be a very attractive asset for the next generation.
This is one reason Roth conversions can sometimes make sense even when the person doing the conversion isn't expecting to spend the money themselves.
They may be thinking about the next generation.
The strategy becomes:
Pay some tax today in order to potentially leave a more tax-efficient asset to your heirs later.
Whether that makes sense depends on your tax bracket, your expected future income, the size of the account, your beneficiaries and a number of other factors.
But it's a conversation worth having.
Don't Overlook the Taxable Investment Account
Here's one that surprises people.
Many investors assume retirement accounts are automatically better for legacy planning because of their tax advantages.
Not necessarily.
A taxable brokerage account can have a significant estate-planning advantage because appreciated assets may receive a step-up in cost basis at death under current federal law.
Here's a simple example.
Suppose you purchased stock for $100,000 and it's worth $500,000 when you die.
If you had sold the investment during your lifetime, you could potentially owe capital-gains tax on the $400,000 gain.
But assets that receive a step-up in basis at death may have their cost basis adjusted to the asset's fair market value at death.
That can substantially reduce or even eliminate the built-in capital gain for your heirs if they sell the asset shortly after your death.
There are important exceptions and nuances, and tax laws can change, but this is one reason I don't automatically tell clients to spend down their taxable investment accounts first.
Sometimes those assets can be extremely valuable from a legacy perspective.
So Which Account Is Best for Your Heirs?
There isn't a universal answer.
But when I'm looking at a client's legacy plan, I generally think about the major account types this way:
Traditional IRA or 401(k)
Potential advantage:
You received a tax deduction or deferral while working and were able to grow the money tax-deferred.
Potential legacy drawback:
Beneficiaries may owe ordinary income tax on withdrawals, and inherited retirement accounts are subject to specific distribution rules.
Often best for:
Retirement spending, charitable giving in certain circumstances, or situations where the tax benefits during your lifetime outweigh the potential tax cost to heirs.
Roth IRA or Roth 401(k)
Potential advantage:
Qualified withdrawals are generally tax-free, making Roth assets potentially very attractive to beneficiaries.
Potential legacy drawback:
You give up the upfront tax deduction associated with traditional contributions, and there are still rules governing inherited Roth accounts.
Often best for:
Tax-free retirement income and potentially passing tax-efficient assets to the next generation.
Taxable investment account
Potential advantage:
Liquidity and flexibility during retirement, plus the potential for a step-up in cost basis at death for qualifying assets.
Potential drawback:
You may owe taxes on dividends, interest and realized capital gains during your lifetime.
Often best for:
Flexibility, liquidity and potentially efficient transfer of appreciated assets to heirs.
The important word throughout all of this is "potentially."
There isn't one account that is always best.
What About Leaving Money to Charity?
There's another wrinkle that deserves attention.
If you have charitable intentions, a traditional IRA can sometimes be a very efficient asset to leave to charity.
Why?
Because a qualified charity generally doesn't pay income tax on retirement-account distributions.
That means the tax characteristics that make a traditional IRA less attractive to an individual beneficiary can make it an excellent charitable asset.
This can lead to an interesting estate-planning strategy:
Leave tax-inefficient assets to charity and more tax-efficient assets to your children.
For example, instead of automatically splitting every account equally among your beneficiaries, you might determine that your children receive more of the Roth and taxable assets while a charitable organization receives some or all of the traditional IRA.
The result could potentially be more efficient for everyone involved.
Your Beneficiary Designations Matter—A Lot
One of the simplest legacy-planning mistakes I see is failing to keep beneficiary designations updated.
Your IRA, 401(k), Roth IRA and other accounts typically have beneficiary designations that determine who receives the account when you die.
Those designations can be extremely important—and in many cases, they operate differently from what your will says.
That's why I encourage clients to review beneficiary designations as part of their overall estate plan, particularly after major life events such as:
Marriage
Divorce
Birth or adoption of a child
Death of a beneficiary
Significant changes in wealth
Changes to an estate plan
Having the right investments in the right accounts is only part of the equation.
You also want to make sure the money actually goes where you intend it to go.
Legacy Planning Isn't Just About Leaving the Most Money
This is perhaps the biggest point I try to make with clients.
Legacy planning isn't simply about accumulating as much money as possible.
It's about being intentional about which assets you spend, which assets you preserve and which assets you ultimately transfer.
You may have spent decades building your retirement portfolio.
Now you have another job:
Making sure those assets work efficiently for the people and causes you care about.
That might mean using your traditional IRA for retirement income while preserving your Roth IRA for your children.
It might mean holding appreciated investments in a taxable account rather than automatically selling them.
It might mean using charitable strategies to transfer tax-inefficient assets.
Or it might mean doing Roth conversions during lower-income years specifically because you want to leave a more tax-efficient asset to your heirs.
The right strategy is different for every family.
The Question I Encourage Clients to Ask
When we talk about retirement planning, the conversation often starts with:
"How much do I need to retire?"
But once you've accumulated enough to meet your own needs, I think another question becomes just as important:
"How do I want my money to move to the next generation?"
That's where investment accounts, tax planning and estate planning start to overlap.
And that's also why I don't think legacy planning should wait until you're sitting down with an estate attorney.
Your estate plan may determine who receives your money.
But your investment and tax strategy can have a major impact on how much they actually receive.
If you're approaching retirement and expect to leave a meaningful amount of money to your children, grandchildren or charity, it's worth looking at your portfolio through a different lens.
Not just:
"How is my portfolio invested?"
But:
"Am I holding the right investments in the right accounts for the legacy I want to leave?"
That question can lead to some very different—and potentially much more tax-efficient—planning decisions.
Have questions?…reach out!
Disclaimer: This material is provided for educational and informational purposes only and is not intended as individualized investment, tax, legal, or accounting advice. Tax laws and regulations are subject to change, and the information discussed may not apply to every situation. Please consult with qualified tax and legal professionals regarding your specific circumstances before making financial decisions.