It seems logical: when a parent passes away and a child inherits an IRA, just close the account and transfer the assets to yourself. But that’s a big mistake that could generate a huge tax bill. Instead, use an IRA-Beneficiary Distribution Account, also known as an IRA-BDA, to allow the funds in the IRA to grow tax free for decades.
When it comes to minimizing a family’s tax burden, it is best to begin while the parents are still alive. In light of the fact that many of us will serve as executors for our parents’ estates, you should speak with them now about their estate planning and money management.
Forbes’ article, “7 Ways to Keep Your Parents' Assets from The Taxman,” offers some strategies to save parents money in their later years and to limit the taxes owed by the estate after their death.
Stocks with losses. A parent may be able to take a tax deduction for stock losses while alive. If dad purchased a share of stock for $500 and it’s currently worth only $300, then he can likely deduct the difference should he sell it now at that price. If he decides not to sell, upon his death, what he originally paid no longer matters, and any loss is no longer tax-deductible.
The “stepped-up basis” rule states that the value of the asset for tax purposes, will be its value on the date of death, not its purchase price. However, an executor of a large estate subject to estate taxes can elect to set the “basis” (value) of all estate assets at six months after the owner died instead of the date of death. But there’s a limit of losses that can be taken in a given year, and losses carried forward disappear upon death for income tax purposes.
Stocks with gains. If a parent holds stocks that have increased in value, the stepped-up basis rule can be a tax saver when they pass away. Therefore, if mom purchased a share of stock for $100 several years before her death, and on the date she died it was worth $1,000, applying the stepped-up basis rule, there will be no income tax due on the $900 gain, if the stock isn’t sold until after her death.
Manage IRAs strategically to minimize taxes. If IRA funds are sold while a person is alive, any taxes owed will be taxed at his or her individual tax rate. After death, the beneficiary can take a lump sum distribution or choose to let the IRA continue to grow, with taxes deferred through the IRA-BDA. With an IRA-BDA, the beneficiary gets payments annually over his or her expected lifetime, with any undistributed amounts released to their estate at death. To manage a parent’s IRAs so it is taxed at the lowest rate possible, seek the help of a professional. With an IRA-BDA, the tax deferment is worthwhile because usually the money you’d have paid in taxes can earn interest for years.
Large estate. If parents will have a large estate, they can give money to potential beneficiaries while they’re alive. Estates above $5.45 million are taxed at a top rate of 40%. As a result, if parents have an estate large enough to be subject to the estate tax, they can help lower the tax liability of their eventual estate by giving money to beneficiaries now. There are limits on the amount of money that can be gifted without tax consequences. It is $14,000 per person for 2016.
Trusts. When properly and appropriately structured, trusts can keep assets from having to go through probate. Trusts can be complex, requiring annual tax returns to be filed and in some situations, naming trustees to manage the trusts and the investments, often for a fee. An estate planning attorney with experience in trusts will be able to help you decide if this is a useful tool for your estate.
Reference: Forbes (November 22, 2016) “7 Ways to Keep Your Parents' Assets from The Taxman”