Income Taxes and Estate Planning

The financial press generates numerous articles about federal estate transfer taxes, often detailing the misadventures regarding the estates of the rich and famous. However, only 1% of estates generate any estate transfer taxes. A working knowledge of the rules applying to possible income taxes, however, is more relevant to many more estates. Parents who are desiring to treat multiple children or heirs equally are sometimes surprised to learn that bequeathing equal dollar amounts will not be equitable after Uncle Sam’s claims are considered. 

This inequity is caused by the differing income tax treatment given to various financial asset types when passing through an estate. Assets held by the deceased in traditional Individual Retirement Accounts (IRA) and employer sponsored plans (401k’s, 403b’s, 457’s) were generally never taxed while the decedent was alive and are termed “income in respect to the decedent” upon their passing. This designation means the recipient beneficiary will have to include distributions from these inherited accounts on their own income tax returns. Roth IRA’s and Roth 401k’s are an exception here as distributions from these accounts would not generate any tax liability for an heir.  

Assets held by the decedent in taxable brokerage and mutual fund accounts are treated very differently. These assets will receive a “stepped-up” cost basis when the original owner passes. This means the cost basis for an heir becomes the date of death value* rather than the cost basis of the original owner. If the decedent had highly appreciated stocks or mutual funds with huge unrealized capital gains, this presents no consequence for the heirs as they can subsequently sell the inherited stock or mutual fund and calculate their gain or loss as if they had bought the security on the original owner’s date of death. Accounts held jointly (e.g. Joint Tenants with Right of Survivorship) usually receive a ½ step-up in basis for the surviving party.

So, it is easy to see how two individuals receiving equal dollar inheritances may wind up with very divergent amounts after their income taxes are considered. The degree of disparity will depend on the tax bracket of the inheritor receiving an asset classified as income in respect of the decedent. Those seeking to treat heirs equally should take this into consideration.   

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.

*In rare circumstances, an alternate valuation date of six months after the date of death may be beneficial and is an option for heirs.