There are a lot of factors to consider when developing an estate plan that can minimize taxes. Learn the differences between estate tax versus inheritance tax.
Beneficiaries can look to minimize taxes on property or money they receive
Heirs may be responsible for taxes on some retirement plans
No one likes to think about a serious illness or death, but developing an estate plan can be a loving way to take care of your family after you’re gone. The basic components of an estate plan could include a will, a living trust, and the power of attorney. But the first step is to create a strategy.
Look at it this way: If you don’t have an estate plan, the authorities will make one for you after the fact, and the result could be far from what you intended. U.S. laws vary from state to state, with different amounts directed to spouses and children depending on where you live.
There are a number of tax considerations to take into account when you develop your estate plan, including how those who receive your assets will be taxed.
As always, it’s best to consult with a tax attorney regarding your specific situation and to comply with changing laws.
Unless your family counts among the wealthiest 2% of Americans, the estate tax probably won’t affect you. According to the Tax Policy Center, generally, fewer than 0.15% of U.S. estates must file tax forms, with only 0.07% of estates paying tax. The federal estate tax is essentially a transfer tax on property including cash, real estate, and stock paid by the heirs.
Basically, the estate will need to file an estate tax return with combined gross assets exceeding the exemption limit of $12.06 million per individual in 2022, with a top marginal federal tax rate of 40%. This is up from $11.7 million in 2021. According to the Internal Revenue Service (IRS), you may elect to pass on any of your unused exemption to a surviving spouse.
But don’t confuse the federal estate tax with inheritance taxes on property including money, which are state taxes that require the beneficiary—not the estate—to pay the tax.
The main difference between an estate tax for the ultra-wealthy and an inheritance tax on property imposed by some states is who is required to pay it.
Most states don’t impose an inheritance tax, but several still do. The tax rates on inheritances can be as low as 1% or as high as 20% of the value of property and cash you inherit. Check with your tax attorney or accountant for details.
Inheritance comes in many forms, including inheriting a 401(k) or an individual retirement account (IRA), and there can be different tax implications for each. How to handle an inheritance depends on the receiver’s relationship to the person who has died as spouses have more alternatives than children or other people.
For those receiving an inheritance of retirement assets like IRAs and 401(k)s, know that you have time to make decisions. You generally have a year to make final decisions, but you don’t want to wait until the last minute. And remember that these types of accounts are paid out based on the beneficiary form(s) completed, which avoids going through probate. So keep your beneficiary forms up to date.
Money with traditional IRAs, employer-sponsored retirement plans including 401(k)s and 403(b)s, and annuities would be treated as income of the person who has died, so the heir is generally responsible for the taxes. With Roth IRAs and Roth 401(k)s, there are no taxes due if the account has been open at least five years at the time of the owner’s death. That’s because the deposits were already taxed, and the funds in these accounts are allowed to grow with no tax on the gains. Evaluate carefully which of your beneficiaries receive assets they will have to pay tax on versus assets like Roth IRAs/Roth 401(k)s where taxes are generally not owed, especially if these retirement accounts will be left to non-spouse beneficiaries (like children of the account owner).
Spouses who are beneficiaries of inherited IRAs can treat the IRAs as their own and/or roll them into their current IRAs and preserve the tax benefit. Similarly for a 401(k), those assets can be rolled into spouses’ IRAs with the tax benefit preserved, meaning they don’t have to pay taxes on the assets received at that time. If the spouse beneficiary does not “assume” the IRA or roll the 401(k) into their own name, recent tax law changes continue to allow spouse beneficiaries to spread out the required death distributions from an IRA or 401(k). If the spouse beneficiary does want to begin receiving payments, these distributions can be made over the life expectancy of the spouse beneficiary, thus reducing the tax bite in any one year. Many IRA and 401(k) vendors will either calculate the life expectancy payment for the spouse beneficiary or provide a calculator to ease the process. But beware of some special 401(k) rules: First, many 401(k)s do not allow periodic payments, so if the assets are left in the 401(k), life expectancy withdrawals might not be available. Second, 401(k)s require that the spouse be the sole primary beneficiary, unless the spouse consented to another beneficiary, so a spouse may still be the legal beneficiary even when someone else was named on the form. Make sure to review the options and the beneficiary form before making decisions for 401(k) inherited assets.
Finally, remember that while spouse beneficiaries may treat the account as their own and perhaps avoid taking payments immediately, the required minimum distribution (RMD) rules require that payments begin once the spouse reaches age 72 (or age 70 1/2 if the spouse turned 70 1/2 in 2019 or before).
Children or other non-spouse beneficiaries who are inheriting an IRA have to decide if they want to take money out in periodic payments to spread out the inheritance tax deferral as much as possible, or if they want to take the money right away. If periodic payments are desired, the rules changed for non-spouse beneficiaries with the passage of the Secure Act in 2019. Non-spouse beneficiaries (who are not minors) have only 10 years to distribute all the assets in the inherited IRA/401(k) if they inherited the account in 2020 or later.
The Secure Act 10-year rule says non-spouse beneficiaries have until December 31 of the 10th calendar year following the account owner’s death to take out all the assets.
If the account owner died before 2020, then the non-spouse beneficiary may receive life expectancy payments (similar to how a spouse beneficiary still can). But the Secure Act rules may still kick-in later, if the beneficiary dies before the account is depleted. Thus, if the account owner died before January 1, 2020, and the original beneficiary died on or after January 1, 2020, the successor beneficiary (a beneficiary named by the beneficiary that inherited the original account) must withdraw all assets according to the 10-year rule, even though the original beneficiary was receiving life expectancy payments. This means that all assets must be distributed to the successor beneficiary by December 31 of the 10th calendar year after the original beneficiary’s death.
Both spouse and non-spouse beneficiaries who take the IRA money up front can do so in a lump-sum payment, which will likely have the highest tax assessment. Alternatively, spreading it out over a maximum of 10 years could potentially lower the tax bite for non-spouse beneficiaries. Remember under the Secure Act, generally all non-spouse beneficiaries have until December 31 of the 10th year following the death of the account owner to withdraw all the money from the IRA or 401(k). But even then there are exceptions: Minor children of the account owner may use life expectancy payments until they reach the age of majority in their state and then have 10 years after that to deplete the account. And special rules for beneficiaries that are trusts, estates, and other non-persons also exist, so be sure you do research before naming a non-person beneficiary.
Your estate plan is your legacy and should be treated with care. Consider taking time now to create a plan that will distribute your assets in the manner that you intend. Review and update all your beneficiary forms for IRAs, 401(k)s, 403(b)s, and other retirement plans.
You may want to enlist the aid of a financial consultant to help you develop a strategy to pursue your estate and inheritance planning needs. They can work with you to set concrete goals based on factors such as your age, assets, lifestyle, and net worth. Then they can help you make an actionable plan toward achieving those goals.
Use this checklist to help make sure your estate plan wishes are known and necessary documents are in place.
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