Everything Inheritors Need to Know about Taxes
Everything Inheritors Need to Know about Taxes
Read transcript highlights or listen to the full episode to learn from Sheri Karpa, CPA at Opsahl Dawson:
What tax returns inheritors may need to file
How state estate taxes can trip inheritors up
Surprise tax issues in the estate settlement process
The new rules for RMDs and distributions from inherited IRAs
What the step-up in basis is and how it could affect you
Posted on January 30, 2024 by Katherine Fox.
Everything Inheritors Need to Know about Taxes
What taxes could an executor or an inheritor of an estate need to file?
Sheri: 1:29
When you lose a loved one, life can quickly become overwhelming, especially when you're the executor of an estate or your loved one passes without leaving a will.
The size of the estate and where the loved one owns assets is gonna determine what tax filings are needed.
Right now the federal estate tax threshold stands at 12.92 million. So that is obviously pretty high, um, but it is set to be sunsetting by the end of 2025.
So we're estimating that threshold is going to be pared back to somewhere between 5 million and 7 million, depending on inflation for 2026.
But in the meantime, if your estate is greater than the 12.92 million, you're gonna have a federal estate, federal estate tax filing requirement, and the executor will need to file a Form 706 for the estate.
The federal estate tax rates, or somewhere between, you're gonna pay between 18% and 40% depending on the size of the estate. But again, that's for any assets above the 12.92 million threshold.
So even if the estate is not greater than that, there are returns that are gonna need to be filed. The decedent's final individual tax return is gonna need to be filed, um, and that will include all of their income up to the date of debt.
After the date of death, any income to the estate will need to be reported on a form 1041, and most of the time that income is going to pass through to the beneficiaries on a Form K1, and they'll need to include that on their 1040 themselves.
So often there's, there's a timeframe in between the person's passing and the distribution of their assets to the beneficiaries.
This is the in-between time where a 1041, uh, return for estates and trust will come in. If there's more than $600 of income that is distributed to the estate, you're going to have a 1041 filing requirement. They also might have a state filing requirement depending upon where they live and where they own assets.
For Oregon and Washington, the exemption thresholds are far lower, lower than the federal exemption. So someone may not have to worry about a federal tax filing, but they may have an organ in Washington, excuse me, filing requirement. Um, California does not have an estate tax, um, but 17 states and the District of Columbia. Either have an estate or an inheritance tax.
What are the differences in estate tax between Oregon and Washington?
Sheri: 4:14
Washington's estate tax exemption is currently at 2.193 million. While, Oregon's estate tax exemption is only 1 million.
So you can see how a great deal more people are going to have a state filing requirement, but not a federal filing requirement.
For most states as well, including Oregon and Washington, they are going to make you include all of your assets, including property that you may own in another state. So you know, people might be thinking $1 million, well. That's a lot. I'm never gonna hit that requirement.
And they may be right, but many people also don't realize how quickly your assets can add up. You know that house that you bought 20 years ago for 30,000, or excuse me,$300,000 say that gets a step up in basis as of the date of your death and it could be worth, you know, $600,000 or more now. So that gets the step up.
What is the value of your IRA, your 401k, your brokerage accounts, even your jewelry, vehicles, vacation homes.
So odds are if you, if you own a home and a second home, whether it's a vacation home or a rental, you may see that 1 million threshold a lot faster than you think.
So the other important thing to note is that both Oregon and Washington are going to make you include property that is owned in another state. For example, if you are a Washington resident, but you own a beach house in Oregon, that beach house is not only going to get included on your Washington asset list, but you may end up also with an Oregon filing requirement because you've got a home located there as well.
“The 10 year rule says that you need to deplete that inherited IRA by the end of the 10th year. That’s both traditional IRA and Roth IRAs. So it’s really important that people understand by the end of the 10th year, inherited IRAs have to be empty, whether it’s taxable or not. ”
Could I have to pay estate tax in Oregon even I don’t live there?
Katherine: 5:48
So say I live in a state that doesn't have any state estate tax filing requirements, but I have a $2 million beach house on the Oregon coast. I'm still gonna have to file a state a estate tax turn, return in Oregon and pay Oregon State Estate Tax on just that $2 million house. Is that correct?
Sheri: 6:14
Correct, correct. Yes. Yes. All of your other assets that are outside of the state of Oregon will not be taxed, but the assets that you have in Oregon are going to be.
What is a 1041 tax return for estates and what do inheritors need to know about form K1?
Sheri: 7:16
Yeah, most people are just simply unaware of the entire process, and they're completely lost on top of the fact that they're grieving and trying to take care of just the general final things that need to be done when someone passes away.
So our jobs as the professional are to make the client feel more at ease and to help them solve these problems. You know, communication is gonna be the key.
Most people don't know that they may need to file a 1041. They have no clue what a 1041 is. They just assume that they're gonna be able to file the decedents last return and just divvy everything out and everybody pays the taxes and it's just not quite that simple in a lot of cases.
They also don't know that when a 1041 is filed, there's going to be a K1 showing income reported out to each beneficiary per the will or the trust documents. So a lot of times that's a surprise to them. Um, and to the beneficiaries, they have no idea that they need to wait for that K1 in order to file their tax return. That's a big communication issue there. So you know that that really needs to be communicated with the executors so that they can in turn communicate that to the beneficiaries.
That's probably the number one shock I see from people really, is that they are completely unaware of the additional income that they're gonna have on their tax return.
They also are unaware of, you know, some of the things that are not necessarily going to be taxable to them. You know, if they're left, you know, the, the decedent's checking account or their savings account, you know, not the taxable income.
So just going through the things that are going to be taxed, things that are not going to be taxed, and helping them understand all of those things. And whether or not they can use a certain checking account even to pay some of the bills of the estate, that's really important as well.
The other thing that, that the executor may be mindful of is, is leaving funds in the estate to pay for things like the funeral expenses, attorney and accountant's fees, and the taxes, the decedent's final taxes. They may owe some tax, so if they distribute everything before they're certain all of the expenses have been paid, they may find themselves on the hook to pay some of these things out of their pocket or their share of the inheritance themselves as the executor of the estate.
What do inheritors need to know about the new rules for distributions from inherited IRAs?
Sheri: 10:03
So retirement accounts have gone through quite a lot of changes um, in, in the last few years there have been a lot of changes to retirement accounts and to inherited IRAs.
So they, they've really been through the ringer here. So with the creation of the Secure Act and Secure Act 2.0. They really created some confusion for people and, and you know, we had to do a lot of, of catching up.
So there, there are Pre Secure Act inherited IRAs, and that means any inherited IRA prior to 2020 has different rules.
Then if you, I inherit your IRA after 2020, and to now. Before 2020, you could still use the stretch IRA, meaning that when you inherited the IRA, you get to take RMDs every year based on your life expectancy. So often that's dragged out for for many, many years. So, your RMDs aren't that big, um, but you do have to take an RMD every year.
Now with the passing of the Secure Act they created a whole new batch of beneficiaries with different rules to them.
So we have the eligible designated beneficiary, the non-eligible designated beneficiary, and a non-designated beneficiary. And we're not gonna dig too deep into all of that, uh, for, for this podcast, but know that there are definitely, um, different categories now.
Eligible designated beneficiaries are people like the surviving spouse, um, a minor child, disabled individuals, chronically ill individuals. This is an interesting one, people who are not more than 10 years younger than the IRA owner. That's something you definitely wanna pay attention to.
And then beneficiaries who inherited IRA before 2020, they're on the old stretch rules.
So the Designated beneficiaries can use the stretch IRA still so they can take their RMDs. You have to take an RMD every year, but you get to stretch it out for your life expectancy.
The non-eligible beneficiaries is pretty much everyone else who didn't fit into that care category. They are subject to the new 10 year rule.
Now, the 10 year rule says that you need to deplete that inherited IRA the end of the 10th year. That's both traditional IRA and Roth IRAs. So it's really important that people understand by the end of the 10th year, they have to be empty, whether it's taxable or not.
Do I have to take RMDs from an Inherited IRA?
The IRS is now working on updating rules for RMDs for inherited IRAs. So that's one of the new things that they're working on that still hasn't been fully implemented yet.
So essentially what they're saying is that if the decedent had already reached their required beginning date for RMDs and they were already taking these RMDs, the IRS, once you to still be taking those, they want, they want RMDs to continue.
So what they're saying now is that if they already started taking RMDs. They want you, even though you have to get deplete the account within 10 years, they still want you to take an RMD every year as well. Um, but that is based on your life expectancy. So it will be a smaller RMD, but you're still gonna need to do it until you deplete the account by the end of the 10th year. This does not apply to Roth IRAs. It's for traditional IRAs because the IRS wants the tax money. I mean, it's plain and simple there.
But basically because they have not fully implemented this, they keep kind of kicking the can down the road here. They kicked it down the road last year and they kicked it down the road again this year. So essentially right now what we have is we have this guidance, but it has not been implemented yet.
The IRS has said they are not going to issue any penalties for anyone who has missed these inherited IRA RMDs from 2020 to 2023. Now, this is just on the new ones. If you have a 2019 and prior, it doesn't apply to that. You're supposed to be taking RMDs from those. This is just for the new Secure Act rules.
So if you have not taken those RMDs from your inherited IRA, you're okay. You don't have to technically take them because there's no penalty. And if there's no penalty, why are you gonna take it? I will say that if you're going to take that RMD there, there's, can, you can take the RMD, you can take more than the RMD. We do advise that people do some tax planning to make sure that, you know, you got 10 years and if it's a very large IRA, you might not wanna wait until that 10th year to take everything out. You're gonna pay a lot of tax in that last year. So it's not a bad idea for people to consider taking a little bit each year.
But, um, back to the RMD, you do not have to take it yet. They are going to look at implementing that in 2024. So we just keep up to date with that and we will let everybody know, you know, when they do decide to go ahead and implement that.
But in the meantime, it is not required because it has not been put into place yet by the IRS. So you're okay. Um, just remember you do need to deplete that account. So taking small amounts each year can help.
One of the, one of the biggest things that gets missed in a transition here, um, when someone passes away is an RMD. So, for example, we've got John, he was 78 years old. He has an RMD for 2023 of $25,000, but he passed away before he took the RMD. So what is the executor or beneficiary supposed to do?
They need to take that RMD. It has to be taken regardless of inherited IRA rules. That is a rule that must be followed. The decedent's final RMD must be taken by the end of the year, you're gonna have to get that distributed.
It'll either need to be paid to the estate or to the beneficiary. It needs to be distributed from the IRA prior to the end of the year. The IRS does have some exceptions in place for someone who passes away very late in the year. Often there's way too much going on. You don't have time. You don't even know sometimes that they had an IRA until maybe a couple months later. Um, so the IRS does have, uh, exceptions in place for that.
How could the step-up in basis affect my inheritance?
Sheri: 17:50
Yes. The Step Up in basis is an absolutely fantastic tax benefit for most assets. So when someone passes away, most of their assets get a step up in basis for the beneficiary.
So a simple explanation is this. Scott is single. He passed away this year and he left his estate to his daughter, Jenny.
Scott owned a home, an IRA worth about $500,000, a brokerage account valued at about $250,000, let's say. Scott bought his home 15 years ago for about $250,000 in many of his securities in his IRA and his brokerage account are quite long term and his cost basis is really low on these assets.
That's not a problem for Jenny because Jenny's going to inherit the home at the fair market value as of the date of Scott's death. So if the house is now worth $500,000, that's her basis. Uh, should she, should she decide to sell the home, that's going to be her basis. Even if she sells the home 15 years from now, that is her basis. So she's not going to pay any tax on that in Oregon, Washington, or California, if she is keeping the home.
As far as her inheritance side of that, um, typically beneficiaries who inherit property and then turn around and sell it within a really short time, they don't have any tax implication at all either, because know, all of those sales, while they're quite possibly nice and profitable to the beneficiary, they end up having a loss on paper. Just due to selling expenses, commissions, you know, if you had to do anything to fix up the home, all those kinds of things. So while they still need to report the sale, the tax implication is gonna be usually nothing for them. So that's the house.
Now, the brokerage account.
Brokerage account is also gonna get a step up in basis, so all of the securities held in that a account are gonna get reassessed and assigned a cost basis as of the date of Scott's death. In most cases it is a step up and it's gonna save beneficiary a lot of tax, just it, and it's also considered long term no matter what, because they inherited it.
But here's the thing that a lot of people don't realize as well, that they may also have a step down in basis, and you still have to do it. The step up or down is required. So you have to do either the step up or step down. If it's a step down, it's a step down. You have to do it. Um, most of the time it's not, but sometimes it is. So, um, you just have to know that that is mandatory and you have to do it.
The IRA is the only piece here that does not get a step up in basis. Nothing within the IRA, um, is going to it. It's inherited as is. Those distributions are going to be at ordinary income tax rates. So there's no step, step up in basis in the IRA. So, you know, that one, that one's a, a real simple one.
The more complex issues come in with married couples. So there are community property state rules that come into play at that point. So you've got nine states who are community property states, and those states are Arizona, California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. So here's, here's a couple of examples to show the difference, um, between a community property state and a non-community property state:
So we've got, say Bob and Mary, they live in Oregon, which a non-community property state. They purchased their home 15 years ago for $250,000. Bob passed away this year. So Mary is gonna get a step up in basis for half of that property. So let's say the property is now worth $500,000 to make it easy. Prior to Bob's death, they each had $125,000 in basis in the home because they bought it for 250,000. Split that in two after Bob's death. Mary's basis is now the original half for $125,000 plus half of the new fair market value, which is 250,000. So her total basis is 375,000.
Let's use that same information about Bob and Mary, but they live in Washington, which is a community property state Washington. Mary's going to get a 100% step up in basis on that. So. Her new basis in the home is the fair market value as of the date of death, which is 500,000. You can kind of see where that is, is gonna be helpful in in a community property state. They get a nice little bit bigger step up in basis.
But another keynote that many people are not aware of is that spouses also have up to two years from the date of death to take a married filing joint 121 exclusion. I'll explain in a second. Should they decide to sell the home after the death of their spouse. So that 121 exclusion is when you sell your primary home and you get that $250,000 per person, per owner in married couples. It's a $500,000 exclusion. As long as you've met the requirements, um, of. The 121 exclusion, which we're not really digging into on that, but, um, in this case, the IRS is going to allow you to still use your spouse's $250,000 exclusion and your own as long as you sell the home within two years of the date of their death. So that's a really good planning opportunity for anyone who is thinking about sizing down.
Let’s take the next step together
Understanding everything inheritors need to know about taxes is not easy. Beneficiaries can encounter a wide variety of different situations requiring knowledge and finesse to manage. If you need more help, you can download The 20 Inheritance Terms you Need to Know, or reach out to Katherine Fox, CFP® and CAP®, a financial planner for inheritors to learn how Sunnybranch can help you build a plan to manage taxes during the estate settlement process.
