Death and taxes, the old saying goes, are the only two things in life that are guaranteed. Taxes unlike passing away, can at least be deferred, mitigated and reduced. If your total estate is less than $5.45 million (2016), it is logical to believe that an individual retirement account (or IRA) would pass tax free to your heirs. Indeed this is true, but the taxable event is when the account owner withdraws money in the account. As such, depending on the exact nature of your estate, it may make sense to pass your IRA to your estate, so that your heirs can inherit your IRA. The IRA would avoid being taxed under the estate tax, assuming the whole of the estate is under the estate tax threshold. That does not make the IRA, however, tax exempt or otherwise free of tax liability. In other words, the IRA is a taxable asset, just not taxable under the estate tax, but rather under tax schema that controls distributions of an IRA, namely income tax schema.
ESTATE TAX VERSUS INCOME TAX
While every estate is unique, the simple formula to determine whether or not your estate passes the estate tax threshold is total assets minus liabilities. If the final tally is over $5.45 million, the amount above $5.45 million is taxable. Let us assume, however, that the estate is $2.5 million and included in that is an IRA worth $600,000. While a regular owner of an IRA must take minimum monthly distributions at the age of 70 and one-half years of age, an owner of an inherited IRA must take distributions at least one year after assuming ownership of the inherited IRA, regardless of the age of the new owner. Thus far the heir did not incur any tax liability for assuming ownership of the IRA. At the one year mark or whenever the heir withdraws the minimum monthly distribution, the heir incurs income tax liability. The IRS has tables and other documentation that indicates what the minimum monthly distribution must be which is a function of the owner’s age.
INCOME IN RESPECT TO A DECEDENT
The IRS treats accounts and assets such as an IRA as ‘income in respect to a decedent’, commonly abbreviated “IRD”. An IRD asset is basically an asset that would have normally been taxable to the decedent had he/she withdrew monies or otherwise triggered a taxable event during his/her lifetime. Other common IRD assets include pension plan accounts, annuities, uncollected salaries or wages, bonuses, earned benefit time, rents due and owing, as well as any capital gains from sales that occurred prior to the decedent passing away but still uncollected. There are many others. All IRD assets require a triggering event to incur tax liability. The triggering event is usually withdrawal of the funds from the asset or account. Each IRD is unique, however, in that the tax scheme that determines their taxable rate are different. For example, in the context of a capital gains tax, there must be a deduction of the cost basis (which may also include a stepped up cost basis due to perhaps the decedent inheriting it from someone else). Capital gains taxes are generally a lower overall tax rate than income tax rate.
Tax liability in the context of an inheritance or as part of an estate can be complicated and any mistake can perhaps cost a small fortune to correct, justify and defend. The best way to address these issues is to consult with an experienced estate planning attorney.