Benjamin Franklin and Daniel DeFoe taught us to rely on two certainties: death and taxes. However, dying does not necessarily lead to taxes. In fact, the federal estate tax exemption in 2019 is $11.4 million per person, which means that assets flowing through more than 99% of the estates this year will not be subject to estate taxes. A handful of states impose their own estate and inheritance taxes, but Georgia is not among them.
As a general rule, assets received as an inheritance do not typically show up on a person’s income tax return. Usually, it is only the dividends and interest earned on inherited property that count as income.
The biggest exception to this rule applies to traditional IRAs and 401(k)s. Because the income flowing into these retirement plans is not taxed at the time it is earned, distributions from those plans are treated as taxable income to the beneficiaries. Just as income tax is due if a retiree pulls money out of a traditional IRA, income tax is also paid by a beneficiary in the year that a beneficiary withdraws funds from that IRA.
The income tax burden on traditional IRAs (as opposed to Roth IRAs), means that the slowest distribution schedule is also the most tax efficient. Individual beneficiaries can use their remaining life expectancies to calculate the minimum IRA distributions and defer most of the income tax liability into future years. Leaving an estate as beneficiary or having no beneficiary at all is sometimes the worst plan because the entire IRA is subject to the “five-year rule” and must be distributed within 5-6 years. The estate then pays the income tax on each of those distributions in the year that they are made. Trusts can also be named as beneficiaries, but the rules there get complicated fast. Some Trusts are subject to the five-year rule, and other Trusts qualify to let the life expectancy of the oldest beneficiary stretch out the IRA distributions. It is a good strategy to review your beneficiary designations with a competent adviser and think about how your legacy could be more tax efficient for your beneficiaries.