You have probably heard the quote from Benjamin Franklin, who in 1789 wrote: “in this world, nothing can be said to be certain, except death and taxes.” Franklin was actually paraphrasing Daniel Defoe from his 1726 book The Political History of the Devil. I like Will Rogers’ take on it some two centuries later: “The only difference between death and taxes is that death doesn’t get worse every time Congress meets.”
I get the question all the time “How much tax do I have to pay on Dad’s (or Mom’s) inheritance?” An the answer is: “It depends.” It depends on the size of the estate, the type of assets in the estate, the change in value of the assets after death and how the assets are titled.
Estate Taxes. If your estate is less than $5.34 million in 2014 ($5.43 million in 2015), no estate taxes will be due upon your death. If you did no estate tax planning and have an estate above this amount, your estate would have to pay an estate tax at the rate of 40% of the excess above this amount. If you have worked hard and saved a lot, then nearly half goes to Washington after your death instead of your loved ones.
The good news is that what you may not know is that the estate tax is actually a voluntary tax. If your estate is above these amounts, Congress has given you many tools to avoid the estate tax. Given enough time and with proper planning, you can disinherit the IRS. You may have to give a little to charities to do it.
After your death, you can generally leave your assets to three classes of beneficiaries, loved ones, charities and the IRS. With proper planning using the tools provided by Congress, you can disinherit one of these classes of beneficiaries. If given the choice, most people choose to disinherit the IRS.
But not everyone. I’ve have seen number of estates in which the deceased did no estate tax planning and left the heirs with huge estate tax bills.
Income Taxes. If you have IRAs, qualified annuities or other retirement plans such as 401(k)s or 403(b)s, the amounts have never been income taxed. The accounts grow income tax free. You are only taxed when you withdraw amounts from the accounts.
If there are any amounts left in these accounts after your death, your beneficiaries will have to report the withdrawals on their annual tax returns. Unless the beneficiaries are charities, they will have to pay income tax on those withdrawals.
The beneficiaries do not usually have to withdraw the entire amounts out immediately after death and pay huge income tax bill. If the beneficiaries are individuals or trusts which qualify as designated beneficiaries under the IRS minimum distribution rules, and the plan allows for it, distributions can be made over the beneficiaries’ lifetimes. This is called a “stretch out” of the retirement plan.
If distributions do not qualify for the stretch out over time, distributions of the entire amount generally have to be made within five years of your death.
Capital Gains Taxes. You may have bought your home in the 70s for $15,000 and now it’s worth $90,000. When the kids sell after your death, do they have to pay capital gains taxes on the $75,000 increase in value of the home? The answer is another “depends”. It depends upon whether you gifted it to them before or after your death.
If the home is transferred to the kids after your death, they get a step-up in tax basis to the value at your date of death. If your home is worth $90,000 at the time of your death, and the kids sell it later for $100,000, they only have to pay capital gains taxes on $10,000, which is only the increase in value since your date of death. The $75,000 increase prior to your death escapes taxation.
However, if you gifted the home to the kids during your lifetime, they get a carry-over tax basis. Their tax basis in the home is the same as yours, $15,000. When the home is sold for $100,000 after your death, the kids have capital gains of $85,000 instead of $10,000. You may have avoided probate with a lifetime gift, but you just might have saddled the kids with a big capital gains tax bill.
Property Taxes: With Proposal A from 1994, your property tax increases are limited to the lesser of the rate of inflation or 5%. If the assessed value of your home, also called the State Equalized Value or SEV, goes higher than the Proposal A amount, your taxable value stays at the Proposal A amount. This is called “capping” your property taxes. You may notice a difference on your property tax bill between the taxable value and the SEV.
When you sell your home or transfer it to your kids, the taxable value will jump up to the SEV. This is called uncapping. If you have owned your home for decades, likely there will be a large difference between the taxable value and the SEV, sometimes even double or triple. This means that when the kids get the home, not only will the taxes increase because the home no longer qualifies for the homestead exemption, the property taxes may double or triple when the taxable value increases up to the SEV.
However, there is a special rule in some instances if you put your kids on your deed as joint owners. When you as a joint owner dies, the property does not become uncapped. The taxable value does not increase as a result of your death. The downsides of this type of planning are twofold.
Firstly, you cannot sell, mortgage or transfer the home to anyone without the kids agreeing to it. When you have joint property, all joint owners have to sign off on these transactions. Secondly, your home is subject to claims of the creditors of any joint owner. If any of your joint owners is sued or gets a tax lien, you could lose your home.
You have options. With proper planning and consultation with a knowledgeable estate planning and tax specialist, you can minimize taxes, minimize expenses and maximize the amount available to your beneficiaries.
By: Matthew M. Wallace, CPA JD
Published edited December 14, 2014 in The Times Herald newspaper, Port Huron, Michigan as: Few things are certain, except death and taxes