Will My Heirs Need to Be Ready to Pay Estate Taxes?

Estate taxes all depend on how on much a person is planning to give to heirs.

Motley Fool’s recent article asks “If I Leave My Retirement Savings to My Heirs, Will They Pay Estate Tax?” The article tells us that retirement accounts like 401(k)s, 403(b)s, traditional and Roth IRAs and others are a part of your taxable estate.

However, unless the total assets of your estate plus any taxable gifts you’ve already given are more than the lifetime exclusion amount, your estate won’t owe estate taxes.

For 2019, this is $11,400,000, and in 2020, the exclusion will be raised to $11,580,000. If you total all of your assets’ value, only the amount in excess of the exclusion will be taxable. Therefore, if you have a $12,000,000 estate and die in 2020, only $420,000 of your assets would be subject to estate taxes.

Let’s look at another example: if your assets, including your retirement savings, total up to $5 million, your heirs won’t be required to pay any estate tax whatsoever.

However, while they may not have to pay estate taxes, remember that withdrawals from most retirement accounts (except Roth IRA accounts) will be deemed to be taxable income. Thus, estate tax or no estate tax, if your heirs are in a pretty high tax bracket, inheriting your retirement savings may increase their tax liability.

Don’t neglect to check with an estate planning attorney about your state’s estate and inheritance taxes. There are a handful of states that have their own estate taxes, and their thresholds may be lower than the IRS’s.

There are now six states with an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.

Each state sets its own inheritance tax exemption, and inheritance tax rates. However, these rates are subject to change at any time with changes to the laws in those states.

Reference: Motley Fool (November 8, 2019) “If I Leave My Retirement Savings to My Heirs, Will They Pay Estate Tax?”

What Should I Do If I Strike it Rich?

There’s nothing quite like getting an unexpected sum of money. That happiness can be magnified when the amounts are six, seven, eight digits or more.

However, the greater the amount you receive, the greater your stress.

Investopedia’s recent article, “Tips For Handling Sudden Wealth” reports that there’s even a stress-related disorder called “Sudden Wealth Syndrome.”

This stress results in the recipients doing things that will threaten their good fortune and may leave them worse off than before they got the money.

Let’s look at few ideas to help you hang onto that new wealth:

  1. Tally your money. Take the time to carefully review all the documentation associated with the windfall. Note the areas you don’t understand and talk with your attorney.
  2. Create a comprehensive financial and life plan. Don’t settle for a cookie-cutter solution. Look for customization that takes into account your circumstances, your goals and your desired legacy.
  3. Be wary of friends and family. A downside of sudden new wealth is that new friends and estranged family members may come out of the woodwork. One idea is to pay yourself a salary, which can put some distance between you and these people.
  4. Don’t buy big ticket items, until you’re comfortable with the advice and understand your new financial position. You should address your taxes on the gain, pay down debts or take a small vacation. However, don’t make too many changes all at once. Talk to your advisors.

More money can mean more problems. Use these tips and consult with your attorney, when deciding what to do with your newfound riches.

Reference: Investopedia (June 25, 2019) “Tips For Handling Sudden Wealth”

As a Trust Beneficiary, Am I Required to Pay Taxes?

When an irrevocable trust makes a distribution, it deducts the income distributed on its own tax return and issues the beneficiary a tax form called a K-1. This form shows the amount of the beneficiary’s distribution that’s interest income, as opposed to principal. With that information, the beneficiary know how much she’s required to claim as taxable income when filing taxes.

Investopedia’s recent article on this subject asks “Do Trust Beneficiaries Pay Taxes?” The article explains that when trust beneficiaries receive distributions from the trust’s principal balance, they don’t have to pay taxes on the distribution. The IRS assumes this money was already taxed before it was put into the trust. After money is placed into the trust, the interest it accumulates is taxable as income—either to the beneficiary or the trust. The trust is required to pay taxes on any interest income it holds and doesn’t distribute past year-end. Interest income the trust distributes is taxable to the beneficiary who gets it.

The money given to the beneficiary is considered to be from the current-year income first, then from the accumulated principal. This is usually the original contribution with any subsequent deposits. It’s income in excess of the amount distributed. Capital gains from this amount may be taxable to either the trust or the beneficiary. All the amount distributed to and for the benefit of the beneficiary is taxable to her to the extent of the distribution deduction of the trust.

If the income or deduction is part of a change in the principal or part of the estate’s distributable income, then the income tax is paid by the trust and not passed on to the beneficiary. An irrevocable trust that has discretion in the distribution of amounts and retains earnings pays trust tax that is $3,011.50 plus 37% of the excess over $12,500.

The two critical IRS forms for trusts are the 1041 and the K-1. IRS Form 1041 is like a Form 1040. This is used to show that the trust is deducting any interest it distributes to beneficiaries from its own taxable income.

The trust will also issue a K-1. This IRS form details the distribution, or how much of the distributed money came from principal and how much is interest. The K-1 is the form that allows the beneficiary to see her tax liability from trust distributions.

The K-1 schedule for taxing distributed amounts is generated by the trust and given to the IRS. The IRS will deliver this schedule to the beneficiary, so that she can pay the tax. The trust will fill out a Form 1041 to determine the income distribution deduction that’s conferred to the distributed amount. Your estate planning attorney will be able to help you work through this process.

Reference: Investopedia (July 15, 2019) “Do Trust Beneficiaries Pay Taxes?”

What Are the Rules About an Inheritance Received During Marriage?

A good add-on to that sentence is something like, “provided that it is kept separate from marital assets.” To say it another way, when an inheritance or any other exempt asset (like a premarital asset) is “commingled” with marital assets, it can lose its exempt status.

Trust Advisor’s recent article asks, “Do I Have To Divide The Inheritance I Received During My Marriage?” As the article explains, this is the basic rule, but it’s not iron-clad.

A few courts say that an inheritance was exempt, even when it was left for only a short time in a joint account. This can happen after a parent’s death. The proceeds of a life insurance policy that an adult child beneficiary receives, are put into the family account to save time in a stressful situation. You may be too distraught to deal with this issue when the insurance check arrives, so you or your spouse might deposit it into a joint account. However, in one case, the wife took the check and opened an investment account with the money. That insurance money deposited in the investment account was never touched, but the wife still wanted half of it when the couple divorced a few years later. However, in that case, the judge ruled that the proceeds from the insurance policy were the husband’s separate property.

The law generally says that assets exempt from equitable distribution (like insurance proceeds) may become subject to equitable distribution, if the recipient intends them to become marital assets. The comingling of these assets with marital assets may make them subject to a division in a divorce. However, if there’s no intent for the assets to become martial property, the assets may remain the recipient spouse’s property.

Courts will look at “donative intent,” which asks if the spouse had the intent to gift the inheritance to the marriage, making it a marital asset. Courts may look at a commingled inheritance for donative intent, but also examine other factors. This can include the proximity in time between the inheritance and the divorce. Therefore, if a spouse deposited an inheritance into a joint account a year before the divorce, she could argue that there should be a disproportionate distribution in her favor or that she should get back the whole amount. Of course, the longer amount of time between the inheritance and the divorce, the more difficult this argument becomes.

Be sure to speak with your estate planning attorney about the specific laws in your state. If there is a hint of trouble in the marriage, it might be wiser to simply open a new account for the inheritance.

Reference: Trust Advisor (October 29, 2019) “Do I Have To Divide The Inheritance I Received During My Marriage?”

What Will New Acts of Congress Mean for Stretch IRAs?
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What Will New Acts of Congress Mean for Stretch IRAs?

The SECURE and RESA acts are currently being considered in Congress. These acts may impact stretch IRAs. A stretch IRA is an estate planning strategy that extends the tax-deferred condition of an inherited IRA, when it is passed to a non-spouse beneficiary. This strategy lets the account continue tax-deferred growth over a long period of time.

If a parent doesn’t need her Required Minimum Distributions, does it make sense to do a gradual Roth IRA conversion and use the RMDs to pay taxes on the conversion? Or should the parent invest the RMDs in a brokerage account?

There are several options in this situation, according to nj.com’s recent article, “With Stretch IRAs on the way out, how can I plan for my children’s inheritance?”

Congress is considering legislation with the SECURE and RESA Acts, that would eliminate the ability of children to create a stretch IRA, one that would let them to stretch distributions from the inherited IRA over their lifetimes.

Under the proposed SECURE and RESA Acts under consideration, the maximum deferral period will be 10 years. If the beneficiary is a minor, the period would be 10 years or age 21.

The best planning strategy for a parent would depend on her overall finances and what she wants for her children’s inheritance.

The conversion to a Roth may be a good planning move, depending on her tax bracket. Putting the money in a brokerage account is also an option.

A parent may also want to think about using the RMD proceeds to purchase a life insurance policy held by an irrevocable trust for the benefit of her children.

It’s best to contact an experienced estate planning attorney, so he or she can review the details of the parent’s finances and help her choose the best options for her situation.

Reference: nj.com (October 15, 2019) “With Stretch IRAs on the way out, how can I plan for my children’s inheritance?”

What Can You Tell Me About a Special Needs Trust?

A special needs trust is a specific type of trust fund that’s created to help a beneficiary with special needs but not jeopardize their eligibility for programs, like Supplemental Security Income (SSI), Social Security Disability Insurance (SSDI) and Medicaid. KAKE’s recent article, “How a Special Needs Trust Works,” says that programs like SSDI and Medicaid can be vital supports for those dealing with disabilities or chronic illnesses.

These programs have income limits to ensure they’re serving those who need them the most. If you were to just give money to your beneficiary when you pass away, it could come in above this income limit.

A special needs trust works around this. That’s because the owner of the funds is technically the trust, not the beneficiary. You also name a trustee to be in charge of disbursing the funds in the trust. Therefore, while the beneficiary benefits from the trust, she doesn’t have control of its assets.

If you are creating a special needs trust for a beneficiary, you must do this before the beneficiary turns 65. And funds from the trust typically can’t be used to pay for food or shelter.

If a person could benefit from a special needs trust, but they themselves own the funds, you can create a first-party special needs trust in which you serve as both the beneficiary and the grantor. These can be complicated to draw up, and states have varying rules determining their validity. A first-party special needs trust has the money that belongs to its beneficiary.

With a third-party special needs trust, the trust holds funds that a beneficiary doesn’t directly own. These are generally used by grantors to allow the beneficiary to start getting money from the trust, even before their death. The funds never technically belong to the beneficiary, so they can’t be used for Medicaid payments. The trust can be used to save money for the beneficiary and future beneficiaries.

The third type of these trusts is the pooled special needs trust. Nonprofit organizations manage assets for a fee, and these organizations pool the funds of multiple trusts together and invest them. When it comes to payments, beneficiaries get an amount equal to their percentage of the pooled trust’s balance.

A special needs trust lets you write down what you wish your funds’ purpose to be, making it legally binding. Special needs trusts are irrevocable, so you can also protect your funds from creditors and lawsuits against the trust’s beneficiary. It lets you help your beneficiary deal with the expenses that come with illness or disability, without hampering their ability to get other assistance.

Reference: KAKE (September 30, 2019) “How a Special Needs Trust Works”

 

Don’t Forget to Update Your Estate Plan

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There are some people who sign their will once in their life and never change it. They may have executed their estate plan late in life, or after they were diagnosed with a serious disease. However, even if your family life and finances are pretty basic, there are still changes in the law that you may need to incorporate into your estate plan.  Some of the people that you named in your will could also have died or moved away.

Forbes’ recent article, “Why You Should Change Your Will Now,” warns us that if you’ve taken the “one and done” approach to your estate plan, think again. In addition to the reasons already mentioned, your assets may have changed dramatically since you signed your will. The plan you put in place years ago, may not have considered new federal and state estate taxes. Now that you’ve accumulated significant wealth that will be passed on to your children, you might need to review your plans for that wealth for your children.

You may want to include grandchildren to help pay for their college education.

It is also not uncommon for parents to want to protect their children from themselves. This can be because of addiction issues or a lack of financial literacy. If that’s an issue, some parents elect to hold monies in trust for adult children, as a way to ensure that the funds will be there throughout the child’s lifetime.

A person’s estate plan should grow with them over time. An estate plan for a twenty-something may be very basic, but a newly-married couple will want to include provisions for their spouse. Parents need to think about providing for and protecting their children. Adult children have another set of concerns and you need prepare for the possibility of divorcing spouses, poor life choices, addiction issues and just poor money management. There are many stages in life when you may need to readjust the provisions for your children in your estate planning documents.

If you haven’t looked at your will in a while, do it now.

Reference: Forbes (August 27, 2019) “Why You Should Change Your Will Now”

Why You Might Want a Charitable Lead Annuity Trust in Your Estate Plan

The IRS has posted an anonymized version of a letter ruling about charitable lead annuity trusts (CLAT), a trust used in estate planning. In case you were wondering, anonymized means that any information in the letter ruling that could be used to identify the parties involved, has been removed.

A CLAT letter ruling could be of interest to those who are using life insurance, annuities, or other instruments in estate planning.

Think Advisor’s recent article, “IRS Posts Charitable Lead Annuity Trust Letter Ruling,” explains that if the taxpayer passes away prior to the taxpayer’s spouse, the trust is supposed to pay specified debts and expenses, then distribute the trust assets to other individuals and trusts.

If the spouse dies first, the trust is supposed to pay specified expenses and make specified distributions of the assets to individuals and trusts. The trust is then supposed to push the remaining assets into a CLAT. The CLAT is then to pay a charity an annuity amount, that is equal to 5% of the fair market value of the initial trust estate.

A CLAT is designed to have a benefit stream that lasts a specified number of years.

Leslie Finlow, a senior technician reviewer at the IRS Office of Associate Chief Counsel for passthroughs and special industries, said in the letter ruling that the IRS will treat the CLAT as having a benefits payment term of a specified term.

While the term will depend on the amount of assets that winds up in the CLAT, determining the term will be possible, when the trust ends up with its share of the estate, she noted.

If the taxpayer, the spouse, and the trust meet a number of conditions, the taxpayer’s estate should be able to take a tax deduction for the present value of the annuity payments from the CLAT, Finlow explained.

“To the extent any estate, succession, legacy, or inheritance taxes are paid from the residue prior to funding the CLAT pursuant to the terms of revocable trust or by the law of the jurisdiction under which the estate is administered, the amount of the charitable deduction in either estate is determined using the actual amount passing to the CLAT after payment of such taxes,” Finlow writes.

Note that a letter ruling gives the views of one IRS official. A private letter ruling, or PLR, is a written statement issued to a taxpayer that interprets and applies tax laws to the taxpayer’s situation.

Reference: Think Advisor (August 19, 2019) “IRS Posts Charitable Lead Annuity Trust Letter Ruling”

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