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January 30, 2012

Tax Planning for Life Events - Inheritance

Heirs reckon with capital gains and income taxes

Many Americans find themselves landing on “Inheritance” as they course along the tax-game board called "Find the Money". Being an heir is a mixed blessing as you grieve the loss of someone close to you. Your inheritance may arrive with a strong emotional connection to your loved one, either joyful or painful. Maybe you’ll add it to an already healthy investment portfolio – or maybe you’ll need to spend cash and reduce financial strain.

In any case, knowing the tax consequences of your inheritance is important. Here we’ll consider typical inherited assets and the taxes associated with them.

If You Inherit Assets
If you receive a gift of stock or real estate, you’re likely to be affected by capital gains taxes. If Aunt Rose leaves you shares of General Electric (GE) worth $200,000, you’re grateful for her gift. But if you sell the shares, what would you owe in tax? Here’s how it might work for you:

Would you rather have column A or B? Thanks to a provision of the Internal Revenue Code, most assets receive a step-up in cost basis to the value on date of death. So if the cost basis of Aunt Rose’s GE stock is stepped-up from what she paid to its value on her date of death just over a year ago (Column B), the taxable gain is only $3,000. You’ll pay just $450 in tax.

While most heirs receive a stepped-up basis, that’s not true if your benefactor died in 2010. The tax law called EGTRRA suspended the step-up in basis for 2010. If Aunt Rose died in 2010, you’ll inherit her cost basis as in Column A and owe $26,250 in tax. Not only that, determining her cost basis may be a challenge unless Aunt Rose kept good financial records, so some research and tax advice may be in order.

If You Inherit an IRA
If you inherit an IRA, cost basis doesn’t matter – traditional IRA distributions are taxed annually at income tax rates. While it’s best to continue deferring the income tax on your inherited IRA as long as possible, your options will depend on the age of the person who died and how you were related.

If You're a Non-Spousal Beneficiary
If you inherit IRA assets from your 68-year-old uncle, you must begin annual distributions and may stretch them over your life expectancy. If you inherit IRA assets from your father who was 79 and taking required minimum distributions, you may base your annual distributions on either your life expectancy or on your father’s remaining life expectancy, whichever is longer.

If You're a Surviving Spouse
If you’re a surviving spouse and a 100% beneficiary, you have the widest range of options. You may:
  • Treat the inherited IRA as your own
  • Roll the IRA into your own IRA
  • Or defer making RMDs until your deceased spouse would have been 70½

It’s your choice.

You Can't Break the IRA - Income Tax Bond
One point is clear. Traditional IRAs are tax-deferred, not tax-free. Someone at some point will need to pay income tax on distributions. It’s tax-smart to stretch out or defer IRA distributions to take advantage of investment compounding – but income taxes cannot be avoided.

What you can avoid is making costly IRA mistakes, like draining your inherited IRA all at once and ratcheting up your tax bracket for that year. You can also make sure you name at least one beneficiary for your own IRA. Otherwise, all the assets will need to be paid out within five years after you die.

As Benjamin Franklin so famously wrote in 1817, “In this world nothing can be said to be certain, except death and taxes.” The two come together in this section of our "Find the Money" tax game, so it’s wise to know what to expect. 

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