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Will my inheritance be subject to income taxation?

by Legacy Plan
May 14, 2020

An inheritance can provide a beneficiary with a financial windfall. However, an inheritance can also come with certain obligations attached to it. One such possible obligation is income tax liability.

We are all familiar with annually filing income tax returns and paying income tax liabilities, but special issues arise concerning the income taxation of an inheritance. This article examines the inheritances received by two sample persons, "David" and "Julie," and the different income tax consequences applicable to their inheritances based on the different compositions of the inheritances.

David's inheritance

David is the sole beneficiary of his deceased father's estate. David's inheritance consists of the following:

  • Real estate of $600,000.
  • Investments of $100,000.
  • The right to receive commissions earned by, but not yet paid to, David's deceased father, of $100,000.
  • The right to receive a bonus earned by, but not yet paid to, David's deceased father, of $100,000.
  • Regular IRA account of $50,000.
  • 401(k) account of $50,000.

Thus, before income taxation, David would receive an aggregate inheritance of $1 million.

Julie's inheritance

Julie is the sole beneficiary of her deceased father's estate. Julie's inheritance consists of the following:

  • Real estate of $600,000.
  • Investments of $100,000.
  • Roth IRA account of $225,000.

Thus, before income taxation, Julie would receive an aggregate inheritance of $925,000.

What rules will apply to determine the income tax consequences concerning David's and Julie's respective inheritances?

General income tax treatment of an inheritance

The general rule is that the receipt of an inheritance by a beneficiary is not subject to income tax liability. This exclusion only applies to the receipt of the inheritance. Once the beneficiary receives the inheritance and earns income from it (from a sale, an investment, or any other source), such "post-inheritance receipt" income is potentially subject to income taxation.

The general exclusion of receipt of an inheritance from income tax liability is subject to two key exceptions - income in respect of a decedent ("IRD") and certain qualified retirement plan distributions.

Exception - income taxation of IRD

IRD is the name given to income that a deceased person would have received had death not occurred. Because most individuals use the cash basis method of accounting, accrued income that the individual does not receive before death will not be included in the deceased person's income. One example of IRD would be a deceased cash basis salesperson's commissions earned, but not yet paid, before death; the commissions are enforceable and accrued, but not taxable to the salesperson until paid. Another example of IRD would be a deceased cash basis employee's bonus earned, but not yet paid, before death; the bonus is enforceable and accrued, but not taxable to the employee until paid.

The receipt of IRD is an inheritance that is subject to income taxation. If received by a deceased person's estate, the estate will be subject to income tax liability on the amount of the IRD. If received by a beneficiary, the beneficiary will be subject to income tax liability on the amount of the IRD. As an item of IRD was not taxable to the deceased person, it will be taxable to the recipient when paid.

It is possible that the IRD may also be subject to estate taxation. If federal estate tax liability is paid with respect to the IRD, an income tax deduction may be allowed to the recipient of the IRD for the amount of such estate tax liability.

Exception - income taxation of certain qualified retirement plan distributions

The second key exception of an inheritance that is subject to income taxation relates to certain qualified retirement plan distributions. The beneficiary who receives a distribution from a deceased person's IRA or other qualified retirement plan account - such as a 401(k) account - is generally subject to income tax liability on the amount of the distribution. The concept of taxation of qualified retirement plan distributions is generally similar to the above-described concept of taxation of an IRD; the deceased person would have been subject to income taxation on the distribution if the deceased person received it, but instead, since the beneficiary received it, the beneficiary should be subject to income taxation on it.

Calculating income taxes

The beneficiary does not have to receive the full qualified retirement plan distribution as a lump sum amount. Instead, the beneficiary can defer the receipt of distributions, and thereby the related income tax liability. Under current law, many beneficiaries can defer the receipt of distributions over 10 years; some beneficiaries (surviving spouses, minor children, people not more than 10 years younger than the deceased person, people who are disabled or chronically ill and people already receiving distributions under the prior law in effect before year 2020) can defer the receipt of distributions potentially even longer - over their life expectancies.

This income taxation of qualified retirement plan distributions is subject to two key exceptions. First, a surviving spouse beneficiary of the deceased person can rollover (generally within 60 days after death) the deceased person's retirement account into an IRA or other qualified retirement plan account. If so, the surviving spouse will not be subject to income taxation. Second, the beneficiary of a deceased person's Roth IRA can receive distributions from the Roth IRA without being subject to income taxation. This special treatment of Roth IRA distributions applies because the deceased person already paid income tax liability on the Roth IRA.

What are the income tax consequences concerning David's inheritance?

David will inherit the $700,000 of real estate and investments free of income taxation based on the general rule that the receipt of an inheritance by a beneficiary is not subject to income tax liability. However, the remaining $300,000 will be subject to income tax liability. There is $200,000 of IRD (the aggregate of the right to receive commissions of $100,000, and the right to receive a bonus of $100,000), which will be income taxable to David when received by him. In addition, there are $100,000 of aggregate distributions from the regular IRA account and the 401(k) account, which will be income taxable to David when received by him (David can defer the receipt of these distributions over 10 years). Assuming that David will pay income tax liability at a 35% rate on the IRD and retirement plan distribution income, David's "net after-tax" inheritance is reduced to $895,000.

What are the income tax consequences concerning Julie's inheritance?

Unlike David's inheritance, Julie's inheritance is not subject to income taxation. Julie will also inherit the $700,000 of real estate and investments free of income taxation based on the general rule that the receipt of an inheritance by a beneficiary is not subject to income tax liability. In addition, Julie will not be subject to income tax liability on the Roth IRA inheritance because her deceased father already paid income tax liability on the Roth IRA; this treatment of "post-death" Roth IRA distributions is one of the exceptions to the income taxation of qualified retirement plan distributions. Thus, Julie's "net after-tax" inheritance is $925,000. As a result of income taxation of David's inheritance, Julie receives a larger "net after-tax" inheritance than David, even though Julie's gross inheritance was less than David's gross inheritance.

What planning could David have implemented to increase his "net after-tax" inheritance?

David's income taxation arises because he received income that was not income taxable to his father. Thus, the planning to increase David's "net after-tax" inheritance would involve income being taxable to David's father during his lifetime. In the IRD area, this planning would involve David's father receiving the commissions and bonus before death and then transferring the "after-tax" received commissions and bonus as inheritance to David, without David paying any additional income tax liability.

If the company paying the commissions and bonus would be reluctant to accelerate the payment of these amounts to David's father before payment would otherwise be due, it may be necessary to accept "discounted" amounts of commissions and bonus (provided that the reduction in amounts of commissions and bonus is less than the tax benefit realized from such acceleration of payment).

In the qualified retirement plan distributions area, this planning would involve David's father "converting" the regular IRA to a Roth IRA before death and then transferring the "after-tax" received Roth IRA distributions as inheritance to David, without David paying any additional income tax liability. For this planning to be effective, David's father should be in a lower marginal income tax rate bracket than David, and any adverse effect of accelerating the income tax liability during David's father's lifetime (contrary to the usual goal of deferring income tax liability) will need to be considered.

Other taxation besides income taxation on death

Income taxation of inheritances is one of three general forms of taxation on death in the United States. A second form of taxation is estate taxation - taxation of a deceased person's "taxable estate" (in effect, the deceased person's net worth) on death. While there is both federal and possible state estate taxation, under current law, there are large exemptions ($11,580,000 per person from federal estate taxation) that exclude most persons from estate tax liability. A third form of taxation is inheritance taxation, which is taxation (separate from income taxation) of a beneficiary's receipt of an inheritance on death of another person. There is no federal inheritance tax, and only six states (Iowa, Kentucky, Maryland, Nebraska, Pennsylvania and Tennessee) currently impose a state inheritance tax in some form.

Beneficiaries of deceased persons, such as David and Julie, need to consider all of estate taxation, inheritance taxation, and income taxation, to maximize their "net after-tax" inheritances.

How do I create an estate plan?

There are numerous options and scenarios to consider when developing an estate plan that protects your legacy and achieves your objectives, and important decisions should be made with the advice of qualified lawyers and financial experts. Membership with Legacy Assurance Plan provides members with valuable resources and guidance to develop comprehensive estate plans that take life's contingencies into consideration and leave a positive impact for generations to come. Legacy Assurance Plan members also receive peace of mind that a team of trusted, experienced professionals will assist them in developing legal, financial and tax strategies that will meet their needs today and for years to come through periodic reviews.

This article is published by Legacy Assurance Plan and is intended for general informational purposes only. Some information may not apply to your situation. It does not, nor is it intended, to constitute legal advice. You should consult with an attorney regarding any specific questions about probate, living probate or other estate planning matters. Legacy Assurance Plan is an estate planning services company and is not a lawyer or law firm and is not engaged in the practice of law. For more information about this and other estate planning matters visit our website at legacyassuranceplan.com.

Phone - 844.445.3422
Email - info@legacyassuranceplan.com
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