Q: In considering retirement and estate planning, it is likely I will have a choice between leaving my children funds mostly in conventional taxable investments, or mostly in 401(k) funds from which they would be required to make regular withdrawals. I'm not sure of the better option. … Inheriting a lump sum (taxable account) might be viewed as something to continue as an investment, while regular withdrawals might be treated as spendable extra income. Further, the taxable account funds would, at least under current law, receive a step-up in basis. On the other hand, assuming my children would be in a lower tax bracket than I am, inheriting the 401(k) would seem to make more pure economic sense, and a lump sum could be mishandled.
A: Assuming that there is a reasonable amount of money to pass on, my initial reaction is for you and your children to work with a professional financial planner, if not a team. Rules about inheritance, IRAs and 401(k)s are complicated.
More importantly, the answer to your question will likely emerge from conversations between you and your children. Talk to them about your choices and their options.
These family conversations should include making sure that your finances are arranged so that you can age comfortably. I imagine you have already done this, but just in case, as part of the estate planning exercise you should establish durable power of attorney (in case cognitive decline sets in) and write an advanced health directive.
I reached out to Mark Fischer, a local certified financial planner and author of "Serious About Retiring," to get his professional opinion on your core issue: Which is better, an inheritance composed of taxable or tax-free funds? "Clearly, tax-free is better, because his children will not have to pay taxes," Fischer said. "But how will the different approaches affect Peter during his lifetime?"
He recommends postponing income taxes by taking distributions from nonretirement accounts. The postponed taxes will provide substantial benefits to you. "The taxes not paid will increase his future income, provide more flexibility to meet future health care and other expenses, and increase the inheritance to his children," he said.
More of your children's inheritance is taxable with this approach. But if you include charities as beneficiaries of your estate, you can use 401(k) money for that purpose and avoid income taxes on those amounts.
Chris Farrell is senior economics contributor, "Marketplace," and commentator, Minnesota Public Radio.