Estate Planning Blog Articles

Estate & Business Planning Law Firm Serving the Providence & Cranston, RI Areas

How Much can You Inherit and Not Pay Taxes?

Even with the new proposed rules from Biden’s lowered exception, estates under $6 million won’t have to worry about federal estate taxes for a few years—although state estate tax exemptions may be lower. However, what about inheritances and what about inherited IRAs? This is explored in a recent article titled “Minimizing Taxes When You Inherit Money” from Kiplinger.

If you inherit an IRA from a parent, taxes on required withdrawals could leave you with a far smaller legacy than you anticipated. For many couples, IRAs are the largest assets passed to the next generation. In some cases they may be worth more than the family home. Americans held more than $13 trillion in IRAs in the second quarter of 2021. Many of you reading this are likely to inherit an IRA.

Before the SECURE Act changed how IRAs are distributed, people who inherited IRAs and other tax-deferred accounts transferred their assets into a beneficiary IRA account and took withdrawals over their life expectancy. This allowed money to continue to grow tax free for decades. Withdrawals were taxed as ordinary income.

The SECURE Act made it mandatory for anyone who inherited an IRA (with some exceptions) to decide between two options: take the money in a lump sum and lose a huge part of it to taxes or transfer the money to an inherited or beneficiary IRA and deplete it within ten years of the date of death of the original owner.

The exceptions are a surviving spouse, who may roll the money into their own IRA and allow it to grow, tax deferred, until they reach age 72, when they need to start taking Required Minimum Distributions (RMDs). If the IRA was a Roth, there are no RMDs, and any withdrawals are tax free. The surviving spouse can also transfer money into an inherited IRA and take distributions on their life expectancy.

If you’re not eligible for the exceptions, any IRA you inherit will come with a big tax bill. If the inherited IRA is a Roth, you still have to empty it out in ten years. However, there are no taxes due as long as the Roth was funded at least five years before the original owner died.

Rushing to cash out an inherited IRA will slash the value of the IRA significantly because of the taxes due on the IRA. You might find yourself bumped up into a higher tax bracket. It’s generally better to transfer the money to an inherited IRA to spread distributions out over a ten-year period.

The rules don’t require you to empty the account in any particular order. Therefore, you could conceivably wait ten years and then empty the account. However, you will then have a huge tax bill.

Other assets are less constrained, at least as far as taxes go. Real estate and investment accounts benefit from the step-up in cost basis. Let’s say your mother paid $50 for a share of stock and it was worth $250 on the day she died. Your “basis” would be $250. If you sell the stock immediately, you won’t owe any taxes. If you hold onto to it, you’ll only owe taxes (or claim a loss) on the difference between $250 and the sale price. Proposals to curb the step-up have been bandied about for years. However, to date they have not succeeded.

The step-up in basis also applies to the family home and other inherited property. If you keep inherited investments or property, you’ll owe taxes on the difference between the value of the assets on the day of the original owner’s death and the day you sell.

Estate planning and tax planning should go hand-in-hand. If you are expecting a significant inheritance, a conversation with aging parents may be helpful to protect the family’s assets and preclude any expensive surprises.

Reference: Kiplinger (Oct. 29, 2021) “Minimizing Taxes When You Inherit Money”

Estate Planning Meets Tax Planning

Not keeping a close eye on tax implications, often costs families tens of thousands of dollars or more, according to a recent article from Forbes, “Who Gets What—A Guide To Tax-Savvy Charitable Bequests.” The smartest solution for donations or inheritances is to consider your wishes, then use a laser-focus on the tax implications to each future recipient.

After the SECURE Act destroyed the stretch IRA strategy, heirs now have to pay income taxes on the IRA they receive within ten years of your passing. An inherited Roth IRA has an advantage in that it can continue to grow for ten more years after your death, and then be withdrawn tax free. After-tax dollars and life insurance proceeds are generally not subject to income taxes. However, all of these different inheritances will have tax consequences for your beneficiary.

What if your beneficiary is a tax-exempt charity?

Charities recognized by the IRS as being tax exempt don’t care what form your donation takes. They don’t have to pay taxes on any donations. Bequests of traditional IRAs, Roth IRAs, after-tax dollars, or life insurance are all equally welcome.

However, your heirs will face different tax implications, depending upon the type of assets they receive.

Let’s say you want to leave $100,000 to charity after you and your spouse die. You both have traditional IRAs and some after-tax dollars. For this example, let’s say your child is in the 24% tax bracket. Most estate plans instruct charitable bequests be made from after-tax funds, which are usually in the will or given through a revocable trust. Remember, your will cannot control the disposition of the IRAs or retirement plans, unless it is the designated beneficiary.

By naming a charity as a beneficiary in a will or trust, the money will be after-tax. The charity gets $100,000.

If you leave $100,000 to the charity through a traditional IRA and/or your retirement plan beneficiary designation, the charity still gets $100,000.

If your heirs received that amount, they’d have to pay taxes on it—in this example, $24,000. If they live in a state that taxes inherited IRAs or if they are in a higher tax bracket, their share of the $100,000 is even less. However, you have options.

Here’s one way to accomplish this. Let’s say you leave $100,000 to charity through your IRA beneficiary designations and $100,000 to your heirs through a will or revocable trust. The charity receives $100,000 and pays no tax. Your heirs also receive $100,000 and pay no federal tax.

A simple switch of who gets what saves your heirs $24,000 in taxes. That’s a welcome savings for your heirs, while the charity receives the same amount you wanted.

When considering who gets what in your estate plan, consider how the bequests are being given and what the tax implications will be. Talk with your estate planning attorney about structuring your estate plan with an eye to tax planning.

Reference: Forbes (Jan. 26, 2021) “Who Gets What—A Guide To Tax-Savvy Charitable Bequests”

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