When I first discovered the estate tax (or if you like, “death tax”), way back in the 1980s, the rate could be as high as 55 percent. That’s right, once you got above a certain level, Uncle Sam was taking more than half of what you saved. Nowadays the rate is down to 40 percent, which is still pretty high, but the estate tax doesn’t kick in until you are around $5.5 million, so it doesn’t affect very many people.
There is another tax, though, which can affect even fairly small estates, and the top tax rate on that one is almost 44 percent. It’s the good old income tax.
Most assets, when inherited, are not subject to income tax. The big exception is “tax-deferred assets”. You know what those are: IRAs, 401(k)s, 403(b)s, SEPs, SBS, TSP, deferred comp… all of the kinds of retirement accounts where either it doesn’t count as part of your income when the money goes in, or you get a deduction against your income when you put the money in.
When you have money in a tax-deferred account, and you take it out, you have to pay income tax on what you withdraw. But you don’t have to start taking money out, until you turn 70 and a half years old. When you inherit that kind of account, instead of earning it yourself, you still have to pay income tax on what you withdraw, but there is one big difference: you don’t get to wait until you are 70 and a half. With an inherited account, the mandatory withdrawals start the very next year.
Before I continue, two very important caveats: this doesn’t apply to a spouse who inherits that kind of account; there is a whole different set of rules for the husband or wife. And I’m not talking about Roth accounts here, they have a different set of rules as well. In this column I am just talking about when you leave, for instance, your 401(k) to one of your kids on your death.
So, let’s say my wealthy relative dies, leaving me as the beneficiary on her IRA. It has a balance of $300,000 when she dies. I get a letter informing me of this from Edward Jones, where she was holding the account. There is a form included with the letter, for me to fill out, to tell them what I want to do with the account.
One of the options is a lump sum cash distribution. That sounds good to me, I’ll cash it out and put the money into a bank account somewhere. So I check the box and sign the form, I send it in, and they send me a check. The following April I’m going to get some very bad news: because I cashed it out, the whole thing counted as ordinary income for that year. I just added $300,000 to whatever I actually made that year, which is going to push me up into at least a 33 percent tax bracket. I will be cutting a painfully large check to the IRS for that mistake.
If I don’t want the whole thing to count as ordinary income in one year, I have a simple alternative: I open a beneficiary IRA. I can do that at just about any financial institution, from the local credit union right up to the largest national brokerage firm. If I do that, I just have to withdraw a little bit each year. The required minimum distribution is based on my life expectancy, and since I’m fairly young (quit looking at me like that; I’m not that old!) it will be a small percentage. I can take more out in a given year if I want to, I just have to pay the tax. The advantage is, by not taking it all out in one big chunk, I keep myself in a relatively modest tax bracket.
That’s a simple option, and most of the paperwork will be done by the financial institution I choose. I just have to make sure I tell them to do it. The problem is, most people don’t realize they have that option, so they end up paying a lot more income tax than they have to.
All of this assumes, of course, that the beneficiary is responsible enough to resist pulling money out of that beneficiary IRA too quickly. There are options in that situation. But I’ll save that for a future column. (Get it? I’m saving it for the future… oh never mind).
Kenneth Kirk is an attorney and estate planner in Anchorage. This article should not be taken as legal or tax advice; for specific legal advice you should consult an attorney; for tax advice you should consult one of those people with the green eyeshades.
