The only certainties in life are death and taxes—and estate taxes have always validated that statement. Throughout the century, taxpayers have muddled through exemption amounts, portability, gifting and lifetime exclusions, and generation skipping tax. However, legislation in 2001, 2010, and 2017 went a long way to minimize the tax impact of most estates.
With our current exemption of $12.06 million—$24.12 million with portability for married taxpayers—most families need not think twice about their estate, until the SECURE Act of 2019. While the generation skipping tax falls under the generous exemption amounts, the SECURE Act made some significant changes should you want to leave your retirement accounts to anyone other than your spouse.
Accounts that transfer by beneficiary designation, instead of by your will or probate, have been an advantageous tool in estate planning. Spouses have the luxury of treating the account as if it is their own. It’s non-spouse beneficiaries that are now compelled to pay taxes sooner. Non-spouse beneficiaries are required to deplete the inherited account by December 31, 10 years after the owner’s death. Investors who saved a substantial amount of money in their 401(k) or IRAs, with hopes to leave that money to a non-spouse beneficiary, like a sibling, child, or grandchild, might want to rethink their strategy on who they choose as a beneficiary.
We recently worked with an investor who wanted to name his granddaughter as the beneficiary of his IRA. This wish had many issues. First, the granddaughter is eight years old. She would very likely be under the age of majority when she inherited the account, and minors cannot own legal property of any kind. A guardian or conservator would need to be appointed to manage the inheritance. Since the grandchild’s parents were divorced, both parents could seek custody of the account. Furthermore, if distributions from the IRA are placed in a custodial account, the granddaughter would gain full control of potentially a large sum of money at the age of 18 or 24, depending on the state.
As a non-spouse beneficiary who doesn’t meet any of the exceptions to the rule, the granddaughter would have to deplete the account by the 10th year, which introduces a tax issue. Certain types of income, including inherited traditional IRAs, are subject to the kiddie tax, which means they are taxed at the parent’s highest tax rate after exceeding a threshold amount ($2,300 in 2022).
Good news is that the investor had several options to explore. He could convert a portion of the IRA to a Roth IRA to eliminate the granddaughter’s tax burden since Roth IRAs are passed to beneficiaries income-tax free. However, the Roth IRA would be subject to the same 10-year depletion rule. He could take distributions from the IRA while he is still alive, pay the taxes due, and invest the money in a 529 plan, allowing the assets to grow tax-free until they are used for higher education expenses. Accumulation or conduit trusts are options that would allow him to provide specific instructions as to how the trustee handles the distributions to the minor. Depending on how the trust is structured, the assets could be taxed at higher trust rates.
If you have questions on how to structure inheritances for your beneficiaries, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166
Listen to the August 27, 2022 “Henssler Money Talks” episode.