Many parents fail to get their financial affairs in order, neglecting to take care of such things as wills, living wills and powers of attorney.
For many, I've found, it's because it's a private topic — and an uncomfortable one. But passing an estate on in the most efficient manner possible is a tough thing to manage. Especially if you haven't had at least a general conversation about where your money is, how to get to it and — just as critical — how to minimize the taxes on various types of investments when they're inherited. Therein lies the potential issues, because not all assets are inherited the same and, therefore, are not taxed the same.
Unfortunately, I've found many parents don't know the answers themselves to be able to discuss with their kids. It may be necessary to educate yourself before you can share this information with your family. Here are some things you and your kids should know about.
1. What are the tax ramifications of inherited IRAs?
The stretch option is smart, but try telling that to a kid who sees the money as a one-time windfall that could pay for a new car or even a house. At the very least, talk about the potentially devastating tax consequences of taking a lump sum: Beneficiaries could lose up to 40% or more of the account.
2. What about an IRA rollover?
A non-spouse beneficiary can't roll your IRA money directly into his or her own IRA or 401(k). Doing so could trigger a major tax bill because now the whole amount will become taxable income — and there's no do-over. Be sure your IRA custodian will administer inherited IRAs for your children and will automatically take care of any required minimum distributions so your loved ones don't have to worry about it, because if they don't take the required amount, the tax penalty is 50% of whatever they were supposed to take, plus whatever their ordinary income tax rate would be on that amount. (Distributions from an inherited Roth IRA have similar rules but are tax-free unless the account was established less than five years before.)
3. What tax strings can come with an inherited annuity?
That might be OK, if you've discussed it ahead of time and your child is in a lower tax bracket than you are. But I've seen more than one beneficiary who considered it an unpleasant and unwelcome surprise.
4. How does a step-up in basis work?
So, for example, if you paid $300,000 for your vacation home, but it's worth $500,000 when you die, that becomes the cost basis for your heirs. If your child sells the home for more than $500,000 in the future, any capital gains tax will be calculated based on the “stepped-up basis” of $500,000, not your original basis of $300,000.
5. Who has the financial details that can help?
I've seen parents who have done a pretty good job of talking to their kids about other money matters — budgeting, saving, building good credit, etc. — but drop the ball completely when it comes to preparing them for an inheritance.
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This article was provided by Matt Hausman, founder and president of Old Security Trust Corp. and Old Security Group, and brought to you by the Ronald J. Fichera Law Firm, where our mission is to provide trusted, professional legal services and strategic advice to assist our clients in their personal and business matters. Our firm is committed to delivering efficient and cost-effective legal services focusing on communication, responsiveness, and attention to detail. For more information about our services, contact us today!
This article was written by and presents the views of our contributing adviser. This is not tax advice and should not be construed as such. Please seek professional tax services for more information and advice that will apply to your specific tax situation.