Planning Ahead: How Will Your Estate and Heirs Be Taxed?

A will, a living trust, and the power of attorney are all factors to consider in developing an estate plan that can minimize taxes. Planning for estate and inheritance taxes
5 min read
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Key Takeaways

  • Consider planning for inheritance tax and estate tax with a will and living trust
  • 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.

Estate Tax vs. Inheritance Taxes—Yes, There’s a Difference

Unless your family counts among the wealthiest 2% of Americans, the estate tax probably won’t affect you. The federal estate tax is essentially a transfer tax on property including cash, real estate, and stock paid by the heirs.

Basically, you’ll need to file an estate tax return with combined gross assets exceeding the exemption limit of $11.4 million per individual in 2019, up from $11.18 million in 2018. 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 or 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 or money imposed by some states is who is required to pay it.

  • An estate tax is paid out of the deceased's assets prior to the distribution of the state.
  • The inheritance tax comes into play after the executor of the estate has divvied up and distributed the assets to the beneficiaries. Each individual beneficiary is responsible for paying the tax.

Most states don’t impose an inheritance tax on property or money, 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.

What Happens with an Inherited Retirement Account?

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, Russell said, 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, said Christine Russell, senior manager, retirement and annuities at TD Ameritrade. 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) completedwhich avoids going through your estate. So keep your beneficiary forms up to date.

Money in traditional IRAs, employer-sponsored retirement plans including 401(k)s and 403(b)s, and annuities would have been treated as income of the person who has died, so the heir is generally responsible for the taxes. With Roth IRAs, 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.

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, Russell said. Similarly for a 401(k): That money can be rolled into spouses’ IRAs with the tax benefit preserved, meaning they don’t have to pay taxes on the money received at that time.

Children or other non-spouse beneficiaries who are inheriting an IRA have to decide if they want to take the 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, Russell said. If periodic payments are desired, beneficiaries have until December 31 of the year following the death of the person who named them as a recipient to begin distributions. Spouses also have this option if they do not want to “assume” the inherited IRA as their own.

Beneficiaries who want to spread out the tax deferral as much as possible can opt for so-called “life expectancy payments,” Russell said. Under this model, distributions are based on the life expectancy of the one who inherits the account. This gives younger inheritors an opportunity to stretch withdrawals throughout the rest of their lives.

Those 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 five years could potentially lower the tax bite. Beneficiaries have until December 31 of the fifth year following the death of the account holder to withdraw all the money from the IRA or 401(k) if not using the periodic payment method of withdrawal.

The Bottom Line

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. 

You may want to enlist the aid of a financial consultant to help you develop a strategy to meet 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. 

Estate Planning?

Use this checklist to help make sure your estate plan wishes are known and necessary documents are in place.

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Miranda Marquit is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.


Key Takeaways

  • Consider planning for inheritance tax and estate tax with a will and living trust
  • Beneficiaries can look to minimize taxes on property or money they receive 

  • Heirs may be responsible for taxes on some retirement plans 

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