By Julie M. Sturgeon Certified Public Accountant
At some point on your journey to retirement, your focus will likely shift from your own needs to the needs of those you leave behind. Learning the tax treatment of inherited retirement assets is a good first step toward passing them on wisely.
Not All Assets are Treated Equally
A typical estate can have assets with a variety of tax implications for heirs. On one end of the spectrum, life insurance death benefits are almost never taxable to the beneficiary, making it a popular choice among financial planners.
An investment such as a home, corporate stock (in a taxable account) or jewelry might result in taxes to the heir, but not until sold. Even then, the heirs will receive what’s called a “stepped-up basis,” meaning their cost for purposes of calculating capital gains tax will be the fair market value at the time of their loved one’s passing, not the original cost.
What’s more, an heir can qualify for lower long-term capital gain rates if he or she keeps the asset for one year or more. And tax from the sale of a home can be potentially avoided altogether if the heir lives in it for a certain period of time.
Retirement accounts can come with a sting
Inheriting a qualified retirement account, like a 401(k) or IRA, is a different ballgame. Nonspousal recipients can face a sizable tax bill from the moment they receive the account. Not only can this be a financial shock, but it might require the heir to sell some of their inheritance to pay the tax bill.
As an alternative, a Roth IRA or Roth 401(k) will not cause an immediate tax bill for your heirs. This is because the taxes have already been paid during your lifetime. But there are still special rules to follow, like the one preventing withdrawals of investment earnings from an inherited Roth IRA until five years after the account was opened by the person who passed away.
Tax-efficient ideas to consider
So how should you structure your portfolio and income sources to minimize the tax and financial burden on your family? Consider the following ideas:
Avoid a Hornet’s Nest
- Consider drawing down your regular 401(k) or IRA accounts first, and leave the Roth accounts for your estate, as they have favorable tax status.
- Use your regular IRA to pay qualified higher education expenses for you, your children or your grandchildren while you are living. This can help avoid an early withdrawal penalty.
- Make a qualified charitable transfer of up to $100,000 straight from your regular IRA to your favorite charity (if age 70½ or older) to avoid an income tax event.
- Consider gifting up to $15,000 per year tax-free to each of your family members
While thinking about your estate, compile a list of all your investment and bank accounts and make a record of where each account is held and who to contact when you are gone. Also, write down special instructions for the care and ultimate distribution of personal assets that have meaning to you.
Taking these few steps now could pay dividends for those you leave behind and help avoid the sting of potential arguments during an already stressful time.
Julie M. Sturgeon is a certified public accountant in Valencia with more than 20 years of experience, specializing in individual and business tax issues. For more information, visit santaclaritatax.com.