One day, your kids or grandkids will inherit what you leave behind. Or, you may be the one set to inherit from the older generation. In either case, understanding the different tax ramifications between various asset/account types will go a long way toward avoiding mistakes at the time of inheritance and hopefully set the stage for better tax planning decisions for many years before and after the transfer of assets.
I will talk in terms of three basic "tiers" for this discussion. This is my terminology, these tiers do not exist in the tax code.
Tier 1: Assets that are taxable to the beneficiary.
Also called "ordinary income" property, this is the least favorable asset to inherit tax wise. Examples include:
- Traditional IRA
- Traditional 401(k)
- Non-qualified annuity (though only the growth is taxable, not the amount deposited)
These are the least favorable asset types to inherit for at least two reasons. First, any amount you take out will be taxable (the non-qualified annuity is taxable until you reach basis). So, if you simply withdraw that $300,000 Inherited IRA, you just added $300,000 to ordinary taxable income. Ouch! Next, even if you don't take it out immediately and spread it out in a more tax friendly manner, the growth while you hold it will also be taxed as ordinary income one day. There are specific rules to follow when spreading out these distributions, so make sure the rules are understood and followed.
Tier 2: Assets that are essentially tax-free.
This includes capital gain property which receives a step up in basis at death, making this much more favorable to inherit than ordinary income property. Examples include:
- Mutual funds
- Coin or stamp collections
- Real estate
- Life insurance proceeds (this one is unique in that it's not a capital asset, but the tax treatment is similar once in the hands of the inheritor)
Remember, we're talking about the tax ramifications upon inheritance. Income from or sales of these assets during life will have difference tax consequences.
Tier 3: Assets that are tax-free.
This is obviously the best kind of asset to inherit. Examples include:
- Roth IRA
- Roth 401(k)
A couple of things to consider. First, as I write this I'm reminded of something that often confuses many people in the discussion of asset types or account types. The above tiers refer primarily to how an asset is owned. For instance, the same stock could be owned in a Traditional IRA (Tier 1), in an individual brokerage account (Tier 2) or in a Roth IRA (Tier 3). The ultimate disposition of that stock will have different tax outcomes to an inheritor depending on the wrapper. Therefore, it's the way an asset is owned (its wrapper) that's important.
Next, you might ask "what's the difference between Tiers 2 and 3 since both are tax-free?" I said Tier 2 is essentially tax-free, meaning the inheritor receives the asset without income taxes at the time of inheritance. What happens after that is a different story. Any growth or income after inheritance in Tier 2 will be subject to the normal rules of taxation. However, assets remaining in Tier 3, such as a Roth IRA, can continue to grow and/or produce income which is still tax-free when it's eventually distributed to the inheritor. There are minimum distribution rules for inherited Roth accounts that must be followed, but that doesn't change the tax-free nature of those distributions.
Inheritors need to understand the difference in these tax wrappers. For example, there is a big difference between inheriting a $300,000 Traditional IRA and a $300,000 personal residence. In either case, the inheritor may think they have $300,000 at their disposal. But with the IRA, the government has a tax lien against the account in the amount of the inheritor's marginal federal and state income tax bracket at the time of withdrawal. This makes the IRA less valuable than the house and the IRA will need to be carefully handled over a long period of years to get the best tax result. This may or may not square up with the inheritor's expectations or intended use of the asset.
This is where a novel could be written. Instead, here are the most obvious things to do that apply to most people.
- Be strategic in how you bequest assets. If you have charitable intentions at death, leave Tier I assets to charity. The charity will not pay income tax since it's tax exempt. Conversely, Roth accounts are the most valuable for leaving to people.
- If you will leave Traditional IRAs or 401(k)s to kids (and many of us will), advise them to not take the money and run. Do some homework and get advice when the time comes.
- If you will leave Roth IRAs or 401(k)s, same advice. Yes, that $100,000 Roth could be taken tax-free, BUT, if left in the Roth and distributed over the life of the child, it could be $100,000 plus all future earnings that come out tax-free. This may be even more valuable than the advice in #2.
Any information presented here is general in nature, believed to be reliable as of the date published and is not intended to be and should not be taken as legal, tax, investment or individual financial planning advice. Competent, licensed professionals should be consulted when implementing any kind of financial, estate, tax or investment strategy.