A couple of times a year, we unfortunately get a call from a client whose mom has passed away. It is time for them to start thinking about what will happen to her estate and they need help sorting it out.
Many people assume there are all sorts of death taxes due when their mom passes. Fortunately, in 2017, you are able to die with $5,490,000 in assets without paying estate taxes. This article assumes Mom died with less than $5,490,000.
- Get at least 10 copies of the death certificate. You will need this to transfer ownership of accounts and assets, and settle life insurance.
- Create an organized list of all financial accounts, assets and debts. Locate bank statements, brokerage accounts, tax returns, wills, insurance policies, trust documents, credit card statements, and call her financial planner.
- Contact the court to start the probate process. Probate can be a lengthy, complicated process depending on the complexity of the estate.
- Figure out if you need to pay any debts or taxes. A final Form 1040 will have to be filed for the deceased.
Mom may have died with life insurance, a Roth IRA, a Traditional IRA, stocks and bonds, and CDs and bank accounts. Below we will help you understand how these items are taxed to the heirs.
Life insurance is one of the best things to inherit. In almost all cases the death benefit is completely tax free to the beneficiaries listed on the policy. Call the insurance company, fill out their forms, and send them a death certificate and they can issue you the cash from the death benefit in a few weeks.
The treatment of IRAs varies based on whether the heir is a spouse or a non-spouse beneficiary and whether your Mom dies before or after the required date to take a Required Minimum Distribution (RMD at 70.5 years of age).
If you are a spouse and the sole designated beneficiary, you have the following choices:
- Treat the inherited IRA as your own IRA, meaning you can rollover the account into your own IRA account and all the normal withdrawal rules apply. This is a good option for a spouse who is younger than 70 1/2 and doesn’t need the money.
- Leave the IRA in the name of the deceased. RMDs from the account must be started when the deceased would have reached 70 1/2 if she died prior to the date of RMDs. The RMDs will be computed based on your life expectancy. Any withdrawals by the beneficiary prior to age 59 1/2 will not be subject to the 10% early withdrawal penalty. This is often the best plan for a younger spouse that will need to live on the money.
If you are a non-spouse beneficiary, you will not be allowed to rollover an inherited IRA to your own IRA. A non-spouse beneficiary has the following options:
- Cash out the IRA immediately. If the account was fully funded with pre-tax contributions, the balance of the account would be included in taxable income in the year of withdrawal. There is no 10% penalty, no matter your age, but if you cash out a $100,000 IRA; consider what that will do to your taxable income.
- Stretch the IRA over your life expectancy. You will need to set up an inherited IRA at the institution that your Mom had her IRA. The account will usually be titled “Mom’s Name IRA For the Benefit of You.” You must start taking RMDs the year after your Mom dies. If she had already started taking RMDs, you can use your life expectancy or the life expectancy of your Mom to determine RMDs.
If there are multiple beneficiaries, you are likely going to want to split the IRA into multiple inherited IRAs by 12/31 of the year following death. This will allow each beneficiary to use their own life expectancy for RMDs. If you don’t get the account split in time, the RMDs will be based on the oldest beneficiary’s life expectancy. Once you get your first statement for your beneficial or inherited IRA, you can transfer the IRA to your preferred custodian. You cannot make a 60 day rollover on inherited IRAs. Always make sure you do a custodian to custodian transfer.
- Cash the IRA out over 5 years. The IRS doesn’t require the funds to be taken with any specific frequency, as long as all of the account is withdrawn by December 31st of the fifth year following the account owner’s death. For example, if you need the money, you could take funds out in years 1 and 2, nothing in years 3 and 4, and then the balance in year 5. This option is only available if the owner of the IRA dies before the required beginning date for RMDs.
The 10% penalty for early withdrawal does not apply to a distribution to a beneficiary on or after the death of the owner. However, if a spouse rolls an inherited IRA into their own separate IRA, any subsequent distribution will be subject to the 10% early withdrawal penalty if no other exception applies.
If the owner has already started taking distributions, but had not yet taken the distribution for the year of death, the beneficiary (spouse or non-spouse) will have to take it. Ensuring that the RMD is taken can be a challenge, especially if the owner died late in the year. The penalty for not taking an RMD results in a 50% penalty on the amount that should have been distributed.
Unlike Traditional IRAs, Roth IRAs do not force the owner to start taking Required Minimum Distributions after age 70.5. Unfortunately once the original owner dies, RMDs are required when you have an inherited IRA. If you are a spouse, you can roll your inherited Roth to your own IRA or open a beneficial Roth IRA just as you could with Traditional IRAs. Non-spouse beneficiaries will have the same three options listed above when they open their inherited Roth IRA.
For both spouses and non-spouse beneficiaries, it is important to know how long your Mom had a Roth IRA. If she hasn’t had a Roth IRA open for five years, any withdrawal of earnings by a spouse or non-spouse will be subject to tax but not the 10% penalty for withdrawals before 59 1/2.
Qualified Employer Plans (401(k), 403(b), 457 plans)
The rules that apply to inherited qualified employer plans are basically the same for spouses as the rules for an inherited IRA. The spouse can roll over the plan to their own IRA, or if the plan allows it, the spouse can take distributions over the spouse’s life expectancy beginning in the year the decedent would have turned 70 1/2. If your Mom had already started taking distributions, the spouse would have to take distributions over either their life expectancy or your Mom’s life expectancy if she was younger.
If the plan allows it, a non-spouse beneficiary can stretch out the distributions from the plan over their life expectancy, beginning in the year following the year of death. However, plans do not have to allow this option. Instead, they may require that beneficiaries who keep the assets in the plan must liquidate the assets by the end of the fifth year after death (the 5 year rule).
Non-spouse beneficiaries have the option to rollover the assets into an inherited IRA that is properly titled as an inherited IRA (in the name of the deceased for the benefit of the beneficiary). The rollover must be done via a direct trustee-to-trustee transfer; if the funds are distributed to the beneficiary, it is treated as a distribution and the ability to transfer the funds is lost just like with IRAs. Once the transfer is made, the beneficiary will take distributions over their life expectancy beginning in the year following the year of death.
The ability to do the trustee-to-trustee transfer is only available to the named beneficiary of the account; it is not available to a successor trustee.
Stocks, Bonds, Mutual Funds, and Real Estate
When you inherit these assets, the cost basis is generally stepped-up or down to the value at the date of death of owner. So if you inherit a stock from your Mom who paid $10,000 for the stock and it was worth $40,000 when she died, your cost basis of the stock will be $40,000. The same applies if the stock lost value. If the stock has dropped from $10,000 to $5,000, your cost basis will be $5,000. If you decide to sell these assets soon after you inherit them, there is rarely much tax to pay because of the step up. The gain or loss will be treated as long-term, regardless of how long you hold the investment.
Most brokerage companies will split each asset in the brokerage account by the number of beneficiaries on the account. Each heir will get their own brokerage account and can hold, sell, or transfer the shares.
If you live in a community property state and your spouse dies, the basis of the entire property is stepped-up to the value at the date of death, not just the half of the spouse who passed.
CDs and Bank Accounts
Balances in CDs and bank accounts may have accrued interest that has not been paid as of the date of death. This income will be reported on the final tax return of the deceased. If you inherit these types of assets, you will need to confirm how much is reported on the final tax return of your Mom and you will report the interest income earned from the date of death going forward.
Most of the money you inherit in these accounts will be tax free. The interest rules can get confusing and we can help you work through them to avoid an unexpected tax bite.
If you inherit an annuity, the first thing you need to do is look on the statement to see if Mom held it in her IRA or if she bought it with after-tax dollars. If the annuity is held in an IRA, the rules governing inherited IRAs will dictate the treatment of the annuity. The rest of this discussion will be about annuities held outside IRAs. The second thing you want to do is find out what type of annuity she owned:
- Variable Annuity – this type of annuity is like a 401(k) plan with many different stock and bond subaccounts. Many of these products have complicated riders attached to them that require you doing some serious research to understand what benefits you will receive from inheriting the annuity. Call the annuity company and take the time to understand what benefits you are eligible for as the heir.
- Fixed Annuity – this product is a lot like a tax-deferred CD. It pays a fixed rate of return and is pretty easy to understand.
- Indexed Annuities – these products offer guarantees on the principal and derive their returns based on a market index or indices.
- Annuitized (not common). Your mom may have purchased an annuity to have a fixed income for the rest of her life. Some of these settlement options promise to pay for life or 10 years, whichever is longer. Call the annuity company to see if the payments stop at her death or will continue to you for a certain period of time.
If you inherit any of the first three annuities outside of an IRA, the gains are taxed as ordinary income and the principal is returned to you tax free.
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