Benjamin Franklin famously said that “nothing is certain but death and taxes”. Actually, he wrote it in French, but that’s not my point.
As an estate planner, I deal with death all the time. I also have to be aware of tax issues, although that is less important than it used to be. In fact, for most of my clients, taxes don’t factor into their estate plans in any significant way.
That’s not the way it was when I started out. When I came back from law school, the estate tax was a huge issue. Anyone with an estate of over $600,000 was subject to it, and the tax rate got up to 55% pretty quickly. That’s one for you, one for Uncle Sam, and then a little more for Uncle Sam.
That started to change in 2001, and today the only people who have to worry about estate taxes are the very wealthy. Everything under $12 million is excluded from the estate tax, and that exclusion is easily doubled for a married couple. At 40% it’s still an issue for a few people, but I don’t see many people with those kinds of numbers.
Capital gains taxes do affect some of my clients. You pay capital gains tax when you sell an asset for less than what you got it for. There are ways to eliminate the capital gains tax on death, and a lot of my clients have rental properties which have gone up in value, so I can help them structure things to avoid that tax. But for most people, capital gains tax is only 15%, so it’s not that critical. A nice trick to have up my sleeve, yes, but the payoff isn’t that high.
But then there’s the income tax.
Most inheritances are not subject to income tax. If my rich uncle dies and leaves me his house, which is worth $500,000, I don’t have taxable income in the amount of $500,000. I can move in, or rent it out, or sell it (probably with no capital gains tax either), and not have income for tax purposes.
It is very different, though, if my uncle leaves me his $500,000 IRA.
Incidentally, for the rest of this article I’m going to use “IRA” as shorthand. Most tax-deferred accounts are treated the same for tax purposes when it comes to inheritance. So if you have a 401k, 403b, 401a, SEP, federal TSP, Alaska SBS, tax-qualified annuity, SEP, Simple IRA, or 457 deferred comp, think of it as an IRA as you read along. For what we’re talking about here, it’s the same thing.
An inherited IRA is taxable income. How much tax I have to pay depends on what I do with it after I inherit. If I just cash out my uncle’s IRA, or put it into a regular, non-tax-deferred account, the whole thing counts as ordinary income in one year. Assuming I already have even a very modest income, a $500,000 IRA will put me into a tax bracket that is almost 40%. To paraphrase Forrest Gump, life is like a box of chocolates, if you eat it all at once you will pay the price.
I can avoid that high tax rate by rolling the inherited IRA into a beneficiary IRA, and taking it out over time. Until just a few years ago, I could have taken it out over my entire lifetime, which means I would not have to pay very much more than the tax rate I was paying normally. They have changed the law now, so that in most cases I would have 10 years to take the money out, paying income tax only on what I take out each year.
But if I take the money out evenly over that 10 years, I only have $50,000 in additional income each year. I will still pay income tax, and I might be in a slightly higher tax bracket, but it isn’t going to jump me from, say, 12% all the way up to 40%.
All of which works fine for me, because I am a reasonably responsible individual. It doesn’t work so well if I want to leave my IRA to an heir who is not responsible.
Let’s imagine I have a son named Freddie. I love the kid, but he is irresponsible as all get out. If I leave him a lot of money, he will probably blow it on booze, or sports cars, or his greedy girlfriend. With regular, non-IRA money, the answer is pretty simple. I put it into a living trust, and give the trustee some instructions about how to pay it out. But with an IRA, it becomes more complicated. In order to make this work, and not end up having a big chunk of my estate paid to Uncle Sam, I may need a different kind of trust called an “accumulation trust”. I can still accomplish what I want, but it will be more complicated.
But then, taxes always make things more complicated.
And as Forrest Gump also said, “that’s all I have the say about that”.
Before I let you go, I want to explain something about last month. When I was looking for some examples of amusing myths people believe are true, I thought I would use a misconception about a former politician who, after all, hadn’t run for office in about 14 years. So I turned my politically innocuous column in to the Senior Voice, and between then and when the next issue came out, our congressman died, that same former politician declared for the vacancy, and suddenly it started to look like I was using this column to assist an active candidate.
I have always tried to keep this column politically neutral. I have my political opinions, but the point of this column has always been to educate people, regardless of their political leanings, about topics that may be useful to them. Senior Voice has always tried to stay neutral as well, and I respect that. So from now on, I will only make references to politicians if they are safely deceased. Like Benjamin Franklin or Forrest Gump.
Kenneth Kirk is an Anchorage estate planning lawyer. Nothing in this article should be taken as legal advice for a specific situation; for specific advice you should consult a professional who can take all the facts into account. Was Forrest Gump a politician? Well, he should have been.
