Death is a natural consequence of life and most of us will have assets of some sort to leave behind for others at our passing. How does that transfer work? What are the tax implications? What do you need to consider?
Assuming the asset is titled jointly with your spouse, regardless of the type, the transfer is both estate and income tax free. The same is typically true if an asset is owned by a trust. Tax deferred assets such as IRAs or 401ks transfer via “beneficiary designation,” avoiding probate.
The taxation is very different for retirement assets than for a house or even a brokerage account.
The rules become even more complicated if the beneficiary is not your spouse nor owned jointly with them. Retirement assets will be dispersed as the beneficiary form directs. If your spouse is your beneficiary, assets will be based on their life expectancy and IRS regulations. They will pay taxation at their marginal rate on the distributions and could also be subject to a 10% early distribution penalty if they are under age 59.5.
Determining how the spouse accepts the retirement assets is critical from a tax perspective.
If a charity is your beneficiary, there are no other income tax requirements. If any other living (non-spouse) beneficiary inherits your retirement assets, they will have to withdraw the entire value at the end of 10 years beginning the year after you die. They can remove income without a penalty over the 10-year period. The money will be taxed at the marginal income rate of the beneficiary each year a distribution is taken.
If the inherited Roth accounts experience no taxation, however, the 10-year distribution requirement is still required.
If the asset is a stock outside of an IRA or real property like farm ground or a home, the beneficiary will receive a “step-up" in basis. Basis is the amount of money that has already been taxed before purchasing the asset.
Step-up in basis means that the recipient’s cost basis becomes the current fair market value at the time of the inheritance. If a farm that had a cost basis per acre of $1,000 was passed on at death to a son or daughter, the basis would be fair market value TODAY. Comparatively, if the farmer sold the land during his life, they would pay taxes on the capital gain on the difference between the selling price today and their original cost basis.
Similarly, if the farm was given to the children while the farmer was alive, the basis remains the original basis and there is no step-up in basis.
When an asset is transferred, who receives the gift is very important from a tax standpoint.
Inheriting assets typically means you’ve lost a loved one. It can be very stressful and confusing. Proceed with professional guidance and try to separate emotions from sound financial planning. This is true for people who have terminal issues as well. Planning before they pass is crucial.