September 12, 2017
In developing a financial plan, the tax treatment of various accounts and investments is critical, not only during the income phase of retirement, but also in legacy planning if a primary goal is to pass assets on to heirs, foundations, charities, etc.
In a future post, we will discuss how retirement income, including Social Security is taxed, but for this article, we will address how things are taxed upon the death of the owner.
Let’s start with one of the most common accounts, the Traditional IRA (this also applies to a 401K, 403B, SEP, and some other less common accounts). When the owner of a Traditional IRA dies, the value of the account passes to the beneficiary or beneficiaries on a fully taxable basis at the beneficiary’s ordinary tax rate, but there is a way to prevent a huge tax hit. The beneficiary is able to “stretch” the IRA by spreading out the income or required distributions from the account, thus spreading out the income over several years and avoiding a bump up in tax bracket. There a few factors that determine specifically how this “stretch” can occur, such as whether the beneficiary is a spouse or not, and also the age of the account owner when they died.
On the other side of the coin from a Traditional IRA is a Roth account (IRA or 401K). Because money going into Roth accounts is taxed when the contribution is made, money coming out of these accounts is tax-free to the beneficiary. However, similar to the Traditional IRA, these accounts can also be “stretched”, and although there isn’t really a tax benefit to doing so, it can allow a beneficiary to continue to own investments that are performing well and may not otherwise be available if the account is liquidated. There is an old adage when it comes to the taxation of Roth accounts – “You pay your taxes on your seeds instead of your crops”.
Another account to consider is a traditional taxable account, often called a brokerage account. In reality, the tax treatment of these accounts is determined by the actual investments owned, but in the majority of cases, we are talking about stocks, bonds, mutual funds, ETFs, and so on. Unlike the previously mentioned accounts, these accounts do not have a beneficiary. Instead, they can be passed by various means, such as through a trust, by way of a Transfer on Death (TOD) document, or by how the account is set up, such as a Joint Tenant with Right of Survivorship. Regardless of how the account holdings are transferred upon death, the receiving party will receive what is known as a stepped up basis. What this means is that the cost basis of the investment being received is determined to be the value of that investment at the date of death. Thus, if that investment were immediately liquidated, there would be zero gain and no taxed owed in that case. And if that investments is held for a longer period and later liquidated, the gain or loss will be determined by the difference the basis and price at the time of sale.
The last account we will discuss is a fairly obvious one, and is the only way to create an immediate, tax-free estate regardless of contributions, and that is life insurance. Although there has been debate and discussion about altering the way life insurance (both the death benefit and the cash accumulation) is taxed, currently the proceeds to the beneficiary of a life insurance policy are passed tax free. This is why life insurance is the most important tool for estate planning and legacy maximization purposes. The owner knows and controls the exact amount of money that will pass on to their beneficiaries, and in most cases it provides a high return with significant leverage. We’ll discuss the mechanics of life insurance and why this is the case in the future, but you should be aware of the tremendous tax advantages life insurance can provide.
Feel free to contact us with any questions about this topic or anything else you would like to discuss, and look for our next post coming soon.