Taxes can be steep for those who inherit.
At the current exemption threshold, few people will be impacted by the federal estate tax.
Although more Americans would be subject to the federal estate tax with the proposed $6 million exemption, many people will still escape an estate tax.
Those who live in states with their own estate tax and a lower exemption will need to plan accordingly to minimize their tax liability.
These are not the only taxes levied when someone dies.
According to a recent Kiplinger article titled “Minimizing Taxes When You Inherit Money,” individuals often fail to account for an inheritance tax within their estate plans.
Consider what happens when inheriting an IRA.
Prior to the SECURE Act, those who inherited an IRA or another tax-differed account could make withdrawals based on their own life expectancies.
This meant the money within the account could continue to grow tax-free between each required minimum distributions (RMDs), as “stretched” over the lifetimes of the beneficiary.
With the passing of the SECURE Act, those who inherit IRAs must choose between transferring the money to an inherited IRA and depleting it within ten years of the death of the original owner or taking the money in a single sum and losing a significant sum in taxes.
Although there are exceptions for spouses and those who have a disability, the majority of heirs will owe taxes on the IRAs they inherit.
Spouses are allowed to roll the IRA money into their own IRA where it can grow tax-free until they reach age 72.
At this time, they must take RMDs and pay the corresponding taxes over their lifetimes.
Roth IRAs do not require distributions and any withdrawals made are free from taxes.
The surviving spouse may transfer these to an inherited IRA and make withdrawals over his or her lifetime as well.
If a non-spousal heir inherits a Roth IRA, it must be depleted within ten years but taxes will not be owed on the withdraws if funded at least five years prior to the date the original owner died.
Because IRAs are the largest asset for many couples and because Americans held more than $13 trillion in IRAs in the second quarter of 2021, most people will inherit an IRA.
The majority of heirs will not be exempt from the ten-year drawdown.
By taking all of the money into cash in a single sum, you will pay dearly in taxes and may even bump yourself up to a higher tax bracket.
In most cases, transferring the money into an inherited IRA and taking distributions over a decade will be better financially.
You will have a lot of freedom on when you choose to take the withdrawals.
At this time, assets like other investment accounts and the family home have fewer regulations.
If you inherit a home or an investment account, it will receives a step-up in cost basis.
What does this mean?
If you inherit an investment worth $50 at purchase and worth $250 at the time of the death of the owner, the investment will be revalued at the $250.
If you sell the stock immediately, you will not owe capital gains taxes.
Should you wait to sell the stock, you will only owe capital gains taxes on the difference between the date-of-death valuation and the valuation at the time of sale.
Although the current administration has sought an end to the step-up in basis, this proposal has yet to be successful.
Both the estates and those who inherit will benefit from including tax planning in estate planning.
Reference: Kiplinger (Oct. 29, 2021) “Minimizing Taxes When You Inherit Money”