Retired Military Finances 201: What Happens When You Inherit Investment Funds?
Taxes Estate PlanningI get a lot of questions about inherited assets and taxes. That's not surprising. It's complicated. So, what does happen when you inherit assets? The first thing to realize is that the act of inheriting assets is not subject to income tax. In limited circumstances you could be subject to inheritance tax at the state level. This is unlikely unless you are not a lineal descendent of person who passed away. Large estates can be subject to Estate Tax, but this tax is paid by the estate itself. But that doesn't mean you'll never pay taxes on your inherited assets.
How Are Inherited IRAs Received and Taxed?
Hopefully, the IRA owner designated beneficiaries for the IRA. If that is the case, and you're one of the beneficiaries, you should be contacted about setting up an inherited IRA and transferring funds into it. The movement of the funds is not taxable. But at some point, you'll need to take funds out of the account and pay taxes (assuming it isn't a Roth IRA).
To start with, if you're not a spouse, the IRA must be empty in 10 years after the date of death of the IRA owner. How you take those funds out will depend on the age of the account owner when he or she passed away. If the account owner passed away after the Required Beginning Date (RBD), you must take out Required Minimum Distributions (RMD) each year based on your life expectancy and the account must be empty in 10 years. This likely means that at least one year you'll need to take out more than the RMD. If the owner passed away prior to the RBD, you only need to meet the empty in 10 rule. Of note, the original owner won't have an RBD for a Roth account.
How are the IRA distributions taxed? Distributions from IRAs are considered Income in Respect of the Decedent. That means they're taxed as ordinary income and are taxed at your marginal tax rate. A couple of things to keep in mind when tax planning for the distributions.
- You want to minimize the taxes across all the distributions. That means if you're in the 22% tax bracket, as an example, you may want to fill up the 22% bracket each year even if it is more than your RMD. Why? Because if you don't you might get a big distribution in year 10 that will push you into the 24% or even 32% bracket and you'll end up paying more taxes over the 10 years than if you had smooth flowed at the beginning.
- Don't forget Medicare premiums. If you're 63 years old or older, your income determines how much you pay in Medicare premiums 2 years in the future. Just like managing your tax brackets, you want to manage your Medicare premiums. A big distribution in year 10 could result in a very large increase in your Medicare premiums. You'll want to look at controlling your Medicare premium, but in the case the big increase in year 10, could be less than small increases in years 1 -9.
How are Inherited Investment Assets Received and Taxed?
Investment assets in brokerage accounts are handled a little differently than IRAs. First of all, you may receive them differently. If the brokerage account was titled Transfer on Death (TOD) or a was held in a trust, then the assets transfer to a beneficiary(ies) much like an IRA. If the account isn't TOD or in a trust, the assets will transfer based on the instructions in the will. This could take some time.
Taxation of assets held in a taxable account is different than IRAs. To begin with, any profit you make on the sale will be taxed at capital gains tax rates. Capital gains tax rates are different depending on whether the gain is long-term or short-term. All inherited assets are treated as long-term. That means for most taxpayers, the rate will be 15%. It could also be 0%, 18.8% or 23.8%, but it will always be lower than your marginal tax rate.
How is the gain determined? Inherited assets receive what is called a step-up in basis. This means your gain will be determined by the difference between the sale price and the value on the date of death. In fact, you could generate a capital loss, which is deductible, when you sell the asset. And, if you sell the asset shortly after death, the tax bill shouldn't be too high.
Other Considerations
Since different accounts are taxed differently you should consider which assets you chose to use to live and/or gift and which assets you intend to leave as an inheritance. For instance, if your tax bracket isn't too high, you might want to take distributions from your IRA to live on and plan on leaving the taxable brokerage account as an inheritance. You'll pay taxes on the IRA distributions, which someone is going to pay those taxes someday anyway, and no one will pay taxes on the capital gains you built up over your lifetime. This is just one example. There are other ways to accomplish generational tax savings too.
Military Finances are Different
Inherited assets aren't a unique military concern. But that isn't always the case. Your TSP account is treated differently than an IRA and many 401(k)'s upon the second death (see article below for more info). An advisor that isn't aware of this issue, could set your family up to pay more in taxes than absolutely necessary. For reasons like this, we think you should work with a financial advisor or planner that deals with the unique financial situations Active and Retired Senior Military Officers and NCOS face. If you'd like to find out how we do that, use the button below to schedule a free initial consultation.
If you found this article useful, you might like the following blog posts:
One Reason to Consider Moving Your Assets Out of TSP - Estate Planning
Military Finances 401: Understanding Gift Taxes
Retired Military Finances 301: Congratulations! You're a Trustee