JUNE 9, 2014 VOLUME 21 NUMBER 21
Our clients are often confused about whether their heirs will owe any taxes on the inheritance they are set to receive. We don’t blame them — it’s confusing. Let us try to reduce the confusion.
The federal estate tax limit was raised to $5 million and indexed for inflation in 2011. That means that a decedent dying in 2014 can leave up to $5.34 million to heirs with no federal estate tax consequence at all. It is easy to double that amount for a married couple. And in 2006, Arizona eliminated its state estate tax — so there is no Arizona tax to worry about. That means that there is simply no tax concern for anyone not worth $5 million or more, right? The 99% can pass their entire wealth to their children without fear of tax consequences, right?
Of course that’s not right — it would be way too simple if that were the case. The world — at least the political world — seems to dislike simplicity as much as the physical world abhors a vacuum. Even if your estate is modest, you need to be aware of the tax consequences of leaving money to your heirs. Here are a few of the more common ways your estate might be subject to taxes on your death:
Living, and dying, somewhere other than in Arizona. About half the states, like Arizona, have no estate or inheritance tax. But that means that nearly half of the states do have a tax; some states tax the estate, and some the recipient of an inheritance. Before federal estate tax changes in 2006, it was possible to generalize about those state estate tax regimens — they tended to look alike. But no more. You need to worry about state estate taxes if you live in one of those states with a tax, if you own real estate in one of those states, or if you have heirs who live in one of those states. The details can be mind-bogglingly complex, and they are beyond our scope here. There are plenty of online resources to look up state-by-state rules — we tend to favor this 2013 article from Forbes magazine, partly because it is engagingly titled “Where Not To Die in 2013.” The information is already a year old as we write this, but not that much has changed, and it will give you a good head start.
Owning retirement accounts. You sort of knew this one already, right? You have an IRA, or a 401(k), or a 403(b) retirement plan, and you’ve named your children (or your spouse, or your helpful neighbor) as beneficiary. But keep this in mind: if you leave, say, $100,000 in an IRA to your children, they are going to receive something more like $70,000 of benefit. With careful planning, they can delay the tax liability — but they will pay ordinary income taxes on what they withdraw. Income tax will be paid by anyone receiving the retirement account (except a charity, of course — they pay no income tax), and at their ordinary tax rates. You might have arranged to minimize your own withdrawals, and pay a very low tax rate on the income you do take out — but your daughter the doctor and your son the architect might pay a much higher tax rate and have to start taking money out of the account immediately after your death.
What can you do about that issue? If you have charitable intentions, you can name a charity as beneficiary of your retirement account. You can leave it to grandchildren, who might pay a lower tax rate (and have more immediate use for the money). You can create a trust that forces your heirs to take the money out very slowly. But at the end of that process, some significant income tax is going to be paid by the recipient of your IRA or other retirement account.
Having income-producing property at your death. Arizona does not have an inheritance tax, so there is no tax cost to receiving an inheritance. Except that sometimes there is a small cost. If you leave an estate including, say, stocks and bonds, or mortgages secured by real estate, or anything else that receives income, your estate may incur a small amount of income tax liability during its administration. That can be true even if you create a revocable living trust, since it will typically take 6-12 months to settle even simple estates. But rather than your estate paying the income tax liability, it usually is passed out with distributions to your heirs. So when your daughter hears that there is no tax on her inheritance, she may be surprised when her accountant tells her she owes income tax on a few hundred — or thousands — of dollars of that inheritance.
Having property that has appreciated since you received it. Income tax is usually due on the gain in value of an asset during the time you held it. Most people realize, however, that when you die most or all of your property receives a “stepped-up” basis for calculation of capital gains. That means that your heirs usually do not pay any income tax on the increase in value during the time you owned property.
But be careful — that is not always true. If you gave the property away before your death, or you inherited it in a trust (like a spousal credit shelter trust), it might not get a stepped-up basis. That can mean that the property your heirs receive carries a significant built-in income tax liability. It might not be due immediately on your death, but it might limit their choices about when to sell or give away the property. This is much more of a problem today than it was just a few years ago — with the proliferation of A/B (credit shelter, or survivor/decedent’s) trust planning in the past three decades, a lot of property is now held in trusts and will not get a stepped-up basis on the surviving spouse’s death.
Owning an annuity. You might have done some clever tax planning by buying a tax-sheltered annuity five years ago. But if you die holding that annuity, your heirs might have to pay the income tax on the income accumulated during the years you have held the annuity, and they might have to pay it immediately. Note that tax-sheltered annuities are not called tax-free annuities — they are just a mechanism to delay the income tax liability to a later date when, one presumes, your tax rate might be lower. If your currently-employed children step into your shoes, that assumption might turn out to have been incorrect.
Planning options. What can you do if you fit into any of these categories? If we are preparing your estate plan, we will talk with you about the issues. Any capable estate planning attorney should be able to see whether you have issues to be concerned about. But that is why we always ask you for detailed information about your assets, your family and your circumstances. Yes, the estate tax regimen has gotten simpler — but that doesn’t meant that the decision-making is necessarily simple.