The Olympic medals don’t come free. Every medal winner in Sochi, from Sage Kotsenburg who won gold in snowboard slopestyle to Julia Mancuso who won bronze in skiing super combined, will owe the U.S. government as much as $10,000 in taxes just for bringing home a medal. The U.S. is one of only a handful of developed countries who tax the world’s best athletes on their success.
Why does this matter in estate planning? Because every financial decision has an estate planning impact and a tax consequence.
When planning your estate, three potential taxes need to be taken into account—income tax, gift tax, and estate tax.
Income tax. In general an inheritance is not considered “income” to a beneficiary. In other words if an adult child inherits $500,000 from their parents via life insurance, a residence, and investment accounts, the child does not have to report that he or she “made” $500,000 in income that year. The glaring exception is if a beneficiary inherits a qualified retirement account. Funds in a retirement account have not yet been reported as “income” to the government, and no freebie is permitted simply because the account owner has passed away.
There are potential major pitfalls if a beneficiary accepts a retirement account with exploring the income tax consequences and variety of choices on how to actually receive the funds. Check out Bonnie’s article on the good and the bad when leaving a retirement account to a minor (http://www.examiner.com/article/the-good-and-bad-about-leaving-retirement-accounts-to-minors).
The bottom line is that if an uneducated beneficiary simply takes all the funds out of the retirement account at once, the beneficiary will have to report the full amount as income for that year, resulting in a potentially huge tax liability. There are options to spread withdrawals out over time, but this isn’t automatic and should be done only with professional and legal guidance.
Gift tax. Gift tax is a tax on the giving of away assets during one’s lifetime. Basically the government does not permit someone on their death bed who owns substantial assets to give everything away the moment before they pass, effectively leaving an estate of $0.
The government requires that gifts made during one’s lifetime be added to the assets owned by that person at death when calculating whether any estate tax is due. (More on estate tax below.)
For any calendar year, one individual is permitted to give another individual up to a set amount in gifts without having to worry about reporting anything to the government. In 2014 the annual exclusion amount is $14,000 (this amount is tied to inflation and changes annually). Once a gift from one person to another exceeds the annual exclusion amount in a calendar year, the excess must be reported to the IRS in the form of a gift tax return. There is no gift tax due as long as the combined amount of all reportable gifts in one’s lifetime—again, the excess for each calendar year—is less than the “estate tax exemption amount.” In 2014 the estate tax exemption amount is $5.34 million.
For example, if a parent gives a child $1,014,000 to a child in the year 2014, the parent would report a gift of $1 million for tax year 2014 (remember $14,000 doesn’t have to be reported). Assuming the parent was not obligated to report any other prior gifts in his or her lifetime, there would be no tax due (simply a tax return due) since the reported amount is less than $5.34 million.
Estate tax. Also called “death tax,” estate tax is tax on the value of an estate at the time someone passes away. Estate tax and gift tax are closely related as at the end of the day, the government requires that you combine all reportable gifts with the estate, which effectively makes up one’s potentially taxable estate.
Using the example above, if the parent passes away in 2014 leaving an estate worth $6.5 million the value of the estate for estate tax purposes is $6.5 million plus the $1 million in reportable lifetime gifts, for a total of a $7.5 million estate. The “freebie amount” in 2014 is $5.34 million, leaving the difference of $2.16 million taxed at a 40% tax rate. The tax due to the government before the beneficiary is entitled to anything would be $864,000.
Bottom line. The upshot is that taxes can complicate one’s estate plan. There isn’t always an easy or straight-forward answer to whether your beneficiaries have a potential tax liability to handle. It depends on prior gifts, what is included in your estate, and what your estate is comprised (retirement accounts vs. other types of assets).
Note from Bonnie, Estate Planning Attorney & Organized Mom: While taxes are a necessary evil, the potential tax liability left behind for loved ones can be managed properly and perhaps minimized. If you want to have an estate planning and tax “chat” or simply start the estate planning conversation, check out your options with us – we’re parents and estate planning attorneys who focus on educating families. Call us to schedule your Life Planning Session (a $750 value) to spend up to two full hours with your attorney as you gain an understanding of the potential tax implications related to your estate.
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