But wait…I thought that estates didn’t pay taxes: inheriting retirement accounts.
You might know that most estates pay no tax at all. However, you might be surprised to learn that inherited retirement accounts could leave you with a whopping income tax bill. Estate planning needs to consider tax consequences for your beneficiaries receiving retirement accounts .
(As always, I am an attorney, but I am not YOUR attorney. Nothing in this post should be construed as legal or tax advice or to create an attorney-client relationship. The information here is purely for informational or educational purposes. You should always consult with a licensed attorney in your jurisdiction about your circumstances. )
Types of Taxes Related to Estates
The state and federal governments have done a great job of developing dozens of different types of taxes. From income tax to excise tax, your family, your business, and even your license may require different types of tax payments.
Estates are no different. If you die owning assets, then your attorney and executor will need to examine a number of potential tax implications. Further, they will need to consider which type of taxes might apply to your estate.
Estate Tax/Inheritance Tax/Death Tax
Initially, most people want to know whether they have to pay any tax on the money that they inherit. No one likes to lose a parent and then turn around and cash in the childhood home to write a giant check to the IRS.
Thankfully, the answer for most poeple is, no. You do not owe any estate tax.
Most people are concerned about estate tax (also sometimes called inheritance taxes or death taxes). Historically, this has been the tax paid on an entire estate. It is the tax owed by virtue of transferring wealth from a decedent to a beneficiary.
Estate and inheritance tax has been as high as 40 and 50% of the net estate for certain classes of heirs or estates. Even now, for those who owe estate tax, they can expect to pay as much as 30%.
The estate tax is taken off the top of the entire estate.
The percentage of the estate tax is taken out of the entirety of the estate and usually becomes a prorated reduction in the value of specific assets.
The estate tax even ropes in non-probate transfers and pay on death assets.
To read more about non-probate transfers and why you might want to avoid probate, check this out.
Paying the tax is the responsibility of the personal representative or trustee depending on your circumstances.
During the estate process the personal representative collects and piles all of the assets belonging to the estate. That total forms the value for determining the estate tax.
Most Estates Aren’t Paying Estate Tax
In recent history, the minimum estate value for paying taxes has been as low as $100,000. However, now, that amount has increased dramatically to $11.7 Million for an individual dying in 2021 or $23.4 Million for a couple dying in 2021.
This means, that no estate has to pay any “estate tax” until the estate exceeds at least $11.7 Million. (for most estates where the decedent died in 2021).
Not many people have to worry about this tax anymore. And, those who do have more than $11.7 Million to pass at death can usually participate in sophisticated estate planning to reduce that number.
One of those estate planning techniques is to make strategic lifetime gifts. However, even gifts may have tax.
Gift Tax
If you give enough gifts during life, you are responsible for also paying gift tax.
Did you know that if you make a gift, you, the giver, not the receiver, pay the tax on that gift?
Oprah giving out all those cars might have had to pay gift tax on all those fancy presents.
However, the US government gives you a free pass on your first $15,000.00 in gifts you make to a single individual each year. This means that if you never give any gifts that exceed $15,000 in a single year, then you never have to pay gift tax. (Again, this could change after 2021).
Annual Exclusion
The $15,000 limit changes from time to time and is called your annual exclusion amount. It is the amount you can exclude from your gift tax reporting.
Most people have no problem giving less than $15,000 away. However, consider the gift of a car, the partial gift of a home, or a down payment for house. These are all gifts that might run afoul of the annual exclusion.
Therefore, theoretically, you could give the portion of your estate that exceeds the $11.7 Million exemption away in $15,000 chunks during your lifetime and never pay any gift or estate tax on that amount.
However, if you give more than $15,000 away in a single year to a single individual, then you are going to need to file against your unified credit.
Gifting and Estate Planning
Basically, the government does not want you to give away $11 Million during your lifetime and another $11 Million at your death without paying any taxes. Therefore, you have to report and pay taxes when the amount exceeds $11.7 Million for decedents dying in 2021.
Even though gift taxes are measured by the amount of money that you give away during your life, the amount of gifts that you have reported against your lifetime exclusion matters to your estate. If you gave more than $11.7 Million away during life, then you probably don’t have any estate exclusion left.
(Portability is a topic that we will not discuss here, but might increase your limit.)
Gift taxes and estate taxes go hand in hand. They are 2 sides of the same coin. Using one during your lifetime leaves you less at death and visa versa.
While you might be quick to dismiss the estate and gift taxes, you need to still be aware of a tax that applies to estates of any size.
Estate Income tax
But wait, there’s more. Even if the estate is valued at less than $11.7 Million, and the decedent did not give away more than $15,000 per person per year during his or her life, the estate might still owe tax.
Many estates are comprised of assets that have significantly increased in value, have rented property, or have generated revenue during the pendency of the estate.
Those gains and income are subject to the Estate Income Tax.
RELATED POST: WHAT’S THE BIG DEAL ABOUT BASIS AND STEP-UPS IN ESTATE PLANNING?
If your estate generates more than $600, then it probably needs to file an Estate Income Tax Return or form 1041. (https://www.irs.gov/instructions/i1041)
During the administration of an estate, the federal government treats the estate as a standalone entity. The estate has its own tax identification number and is required to file income taxes.
So, as the estate assets continue to grow, morph, gain, or generate revenue, the estate is liable for income taxes.
For a handy Probate Executor’s Checklist, check this out.
However, the estate income tax does not apply to every type of asset. Federally qualified retirement accounts, unlike other types of investment accounts, have different income tax rules for estates and individuals.
So, even if you avoid paying estate, gift, and estate income taxes, you may still owe other types of tax.
Retirement Accounts in Your Estate Are Exceptions to the General Rule, and Your Beneficiaries Might Pay Taxes
Most estates can easily avoid estate and gift taxes. Most estates are able to avoid estate income taxes.
However, your family is still beholden to the federal government for the treatment of retirement accounts.
Unlike standard estate assets, retirement accounts like 401Ks, Roths, and IRAs are all federally qualified accounts. Inheriting a traditional 401k or IRA may have serious income tax consequences for your heirs.
In other words, these accounts have artificially constructed tax rules that were created and enforced by the federal government that don’t receive a step-up at death.
For example, in a traditional 401k or IRA, you don’t pay tax on your investment, but you pay income taxes when you begin to draw on it. Therefore, while your beneficiaries may not pay estate, gift, or estate income tax on the gift, they will still be liable for personal income tax.
(Contrastingly, Roth 401ks or Roth IRAs, are after tax money where you already paid tax on the initial investment, but you can withdraw your income at the proper age tax free.)
These federally qualified accounts are subject to different rules during your life and are correspondingly subject to different rules at death.
Unlike your home or other non-qualified investment accounts that receive a step-up in cost basis at death, your federally qualified accounts play by a different death tax scheme.
When the beneficiary is an individual
After the SECURE Act and its subsequent amendments were passed beginning in 2019, inherited 401ks and IRAs had less favorable tax treatment after death.
While beneficiaries prior to the SECURE Act could receive IRAs and 401ks over the course of their lifetime, thereby controlling the amount of income they generated, if any, the SECURE Act changed this.
Now, inherited IRAs and 401ks must be completely liquidated within 10 years of inheriting the IRA or 401k. Therefore, if one child receives a $1,000,000 IRA, then he or she must not only receive the entirety of that account over the course of 10 years but must also pay all associated income taxes over the course of 10 years.
If the beneficiary already has his or her own taxable income, then the amount of tax paid on the inherited IRA or 401k could require the beneficiary to pay a 37% tax on the account each year.
Over the course of the 10 year draw, the beneficiary may pay $300,000 to $400,000 in taxes depending on other deductions, gains, and other personal circumstances.
When the beneficiary is an entity
Further, even though the SECURE Act requires that individuals receive the entirety of the IRA or 401k over the course of 10 years, other entities have as little as 5 years.
If the beneficiary is certain kinds of trusts, certain types of estates, businesses, or other types of entities, then that tax might continue to grow.
If the entity beneficiary must receive the entirety of the account over 5 years instead of 10, then the entity may pay entity tax rates and pay even more than 40% of the account in taxes.
In other words, your IRA or 401k does not receive the same protection against taxes at death as many of your other types of assets.
How to plan for taxes from a retirement account in your estate plan
Now that you understand that federally qualified retirement accounts might have different treatment after your death, you want to know why that matters for your estate plan.
EXAMPLE: Your retirement account and estate planning.
Father dies leaving 2 substantially equal assets:
1. A home valued at $500,000, and
2. A 401k valued at $500,000.
Father decides to do some DIY estate planning and adds son as beneficiary on the house and daughter as beneficiary on the 401k. After all, he heard that there were no estate taxes for estates valued at less than $11.7 Million.
Upon father’s death, son receives the house, sells the house, receives $500,000 in proceeds, and pays no tax.
Daughter, on the other hand, has to choose whether to take the entire 401k and pay all taxes at once or receive the entirety of the account over 10 years and pay taxes in increments as she goes along.
Daughter chooses to take the 401k over the course of 10 years, she misses out on 10 years of use of the money, plus she pays taxes at her marginal rate of 25% each year on the 401k distributions.
Therefore, over the course of 10 years, she paid more than an adjusted $125,000 in taxes on the inherited 401k.
In the end, daughters’ gift was valued at only $375,000 while son received the entire $500,000.
When making gifts of retirement accounts in your estate plan consider:
- Taxes: Whether your estate will owe estate, gift, or income taxes.
- Your beneficiaries’ taxes: Whether your gift will bump your beneficiary into the next marginal tax rate or require that more than 25-40% of your gift is paid in taxes
- Entity: Whether the recipient of your federally qualified account is eligible for a 10 year stretch or only a 5 year distribution.
Passing IRAs and 401ks are a tremendous gift, but keep in mind that they receive very different treatment than your other assets.
When completing your estate plan, you want to be certain that your children, beneficiaries, and your estate planning attorney are involved to coordinate the most advantageous payout of the account.
Ensure that You Understand How Your Retirement Account Impacts Your Estate Plan and the Taxes Your Beneficiary Will Pay
Making joint gifts, reassigning income taxes, or even creating certain types of trusts can help control, limit, and prepare for the taxes associated with receiving retirement accounts.
Unlike houses, investment properties, vehicles, or other non-qualified accounts, federally qualified retirement accounts provide great tax benefit during life. Don’t let those benefits come back to haunt your beneficiaries in the form of enormous tax payments.
When talking with your estate planner about transferring your retirement accounts, talk to your attorney about your children’s incomes, their personal savings, the stretch options, and how much tax your beneficiary can expect to pay.
Don’t try to DIY your estate plan. Consult with a qualified and reputable attorney in your area to create an plan that works for you, your family, and your retirement accounts.