Q&A: The rules have changed on inherited IRAs. Here’s what you need to know

Dear Liz: My husband and I have a combination of traditional and Roth IRAs naming our children and grandchildren as beneficiaries. With the passage of the Secure Act requiring distribution of inherited IRAs within 10 years, we want to revise our plan of leaving all of the investments to our children, as such inherited income would affect their tax bracket also. Do you have recommendations to alter the inherited IRAs to avoid this issue? Our annual fixed income puts us at the top of our tax bracket, meaning we usually cannot manage a traditional IRA to Roth conversion.

Answer: The Secure Act dramatically limited “stretch IRAs,” which allowed people to draw down an inherited IRA over their lifetimes. Now most non-spouse inheritors must empty the accounts within 10 years if they inherited the IRA in 2020 or later.

There are some exceptions if an heir is disabled, chronically ill or not more than 10 years younger than the IRA owner, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. These “eligible designated beneficiaries” can use the old stretch rules, as can spouses. Minor children of the IRA owner can put off withdrawals until age 21. At that point, the 10-year rule applies.

If you had a potential heir who qualifies, you could consider naming them as the beneficiary of a traditional IRA and leaving the Roth money to the other heirs. (The IRA withdrawals will be taxable while the Roth withdrawals won’t.) Or you could leave the IRA to the children in lower tax brackets and the Roth to those in higher tax brackets.

If you’re trying to divide your estate equally, though, these approaches could vastly complicate matters because the balances in the various accounts could be quite different. Plus, predicting anyone’s future tax brackets can be tough.

Another approach is to name your children along with your spouse as the primary beneficiary of your IRA. That way, the children would get 10 years to spend down this first chunk of your IRA money after you die. When your survivor dies, they would get another 10 years to spend down the remainder, giving them 20 years of tax-deferred growth.

Alternately, you could focus on spending down the IRA to preserve other assets for your kids. The stretch IRA rules encouraged people to preserve their IRAs, but now it may make more sense to focus on passing down assets such as stock or real estate that would get a valuable “step up” in tax basis at your death.

Converting IRAs to Roths is another potential strategy for those willing and able. In essence, you’re paying the tax bill now so your heirs won’t have to pay taxes later (although they’ll still have to drain the account within 10 years). It may be possible to do partial conversions over several years to avoid getting pushed into the next tax bracket.

There are a few other approaches that involve costs and tradeoffs, such as setting up a charitable remainder trust that can provide beneficiaries with income. These are best discussed with an estate planning attorney who can assess your situation and give you individualized advice.

Q&A: Taxes on trust’s income

Dear Liz: My father passed away last year leaving an estate that will make us comfortable through the foreseeable future. His holdings are mostly securities that are traded either on the NYSE or the Nasdaq. From our investments, we currently have non-earned income of between $75,000 and $100,000 annually without any other income. After estate taxes are paid for my father’s estate, the annual yield (mostly dividends) will be in the $225,000 to $250,000 range. My question for you is should we keep my father’s holdings within his trust and let the trust pay the taxes on the income, or should we take the income and pay the taxes ourselves?

Answer: Tax rates on trusts are notoriously high. If you have a choice, you probably would want to pay the taxes yourself rather than letting the trust do so. The question is whether you have a choice, and that will be determined by the wording of your father’s trust, Los Angeles estate planning attorney Burton Mitchell says.

Speaking of estate planning attorneys, you need to hire one, along with a tax pro and a fee-only financial planner, so you can get solid, personalized advice on questions like this. You already had substantial income, and you just inherited an estate worth multiple millions, so you’re long past the point when doing it yourself makes sense.

Q&A: Did this child get ripped off?

Dear Liz: My niece’s father remarried when she was a child. Her father and her stepmother bought a house as community property in California. Ten years later, her father died. Not long after that, her stepmother died. The stepmother had no children, and my niece was the only child of her father’s. The stepmother’s niece took the house and sold it, and kept all the proceeds. Was my niece entitled to any of the proceeds?

Answer: Your niece needs to consult an experienced attorney, because the answer depends on a number of factors.

Estate planning attorney Jennifer Sawday of Long Beach points to California Probate Code Section 6402.5, which could give your niece priority over other heirs for the property’s proceeds — but only if the facts line up. If the stepmother died no later than 15 years after the father, didn’t remarry, didn’t have children, didn’t put the home in a trust and didn’t make a will after the father died, then the California probate court could consider your niece an heir, Sawday says.

That’s a whole lot of ifs, and your niece will need expert advice to proceed.

Q&A: How a living trust helps your heirs after you die

Dear Liz: My husband and I made a living trust in 2004. He died in 2018, so his half became irrevocable. But while we were settling his estate, no one mentioned (though I can see clearly in the 2004 flow sheet) that all the assets from his half went into a survivor’s trust, controlled by me. I had the option to disclaim those assets within a year, which I did not do, so now everything is mine. Is this standard? If so, how can it be considered irrevocable?

Answer: The structure you’re describing is pretty standard for living trusts, which avoid probate, the court process that otherwise follows death. Living trusts are considered revocable when they are created, meaning the creators can make changes during their lifetimes. Eventually, the trust usually becomes irrevocable, which means changes no longer can be made.

Your living trust was entirely revocable while both of you were alive. That means you could make changes or cancel the trust entirely. When your husband died, part of the living trust became irrevocable — the part that created the survivor’s trust. You had the option to disclaim those assets, which means refusing to accept them, but you couldn’t dictate where the assets would go at that point or otherwise change the terms of the trust.

If your living trust had created a bypass trust instead, then that would have been irrevocable as well but the structure would have been quite different. The assets in the bypass trust would not become yours. Instead, you would get the income from the assets but they would ultimately be passed to heirs designated by your husband.

As mentioned earlier, bypass trusts can be helpful in blended family situations. They also are used to avoid or reduce estate taxes, which are no longer an issue for the vast majority of people. (A public service announcement: If your estate plan was created prior to 2010, you need to have it reviewed pronto. It’s entirely possible your plan includes a bypass trust that’s no longer necessary and that could needlessly complicate your estate.)

Q&A: It’s easy to squander a windfall. How to make the money work for you

Dear Liz: I’m receiving a $150,000 inheritance soon. After I pay all of my debt, I’ll have approximately $70,000. I’m 51, single with no children and my net income is about $4,400 a month. I’ve rarely been wise or successful with my finances. I have no prior savings, don’t own a home and drive a five-year-old car. Do you have any thoughts for the remaining funds?

Answer: It’s never too late to get better with money. Now would be a great time to examine why you got into debt and what you need to change so that doesn’t happen again.

Windfalls tend to disappear pretty quickly, and it would be a shame if you found yourself back in debt in a few years with nothing to show for your inheritance.

Nonprofit credit counseling agencies affiliated with the National Foundation for Credit Counseling (www.nfcc.org) usually offer help with budgeting, or you could book some one-on-one sessions with an accredited financial counselor or accredited financial coach. You can get referrals from the Assn. for Financial Counseling & Planning Education at www.afcpe.org.

Paying off high-rate debt such as credit cards is a great use of a windfall. Think twice about paying off lower-rate debts such as student loans or car loans, however. You probably have better uses for that money.

You likely need to start saving aggressively for retirement.

If you have a 401(k) at work with a match, you should be taking full advantage of that. (You might draw from your inheritance to replace some of the money that’s being directed into your retirement account.)

Otherwise, you can put up to $7,000 into an IRA or Roth IRA — the usual limit is $6,000, but people 50 and older can make an additional $1,000 catch up contribution. You can dedicate even more money for retirement by opening a regular brokerage account and investing through that.

A windfall also can help you create an emergency fund equal to three to six months’ worth of expenses, as well as provide a starter savings account for your next car.

Resist the urge to replace the one you have, though, because with proper maintenance you should be able to drive the one you have for several more years. Buying new cars every few years is hugely expensive and generally unnecessary since today’s cars can easily drive without major problems for 200,000 miles or more, according to J.D. Power & Associates.

Q&A: Getting a small estate transferred

Dear Liz: My brother passed away three years ago leaving no will. All of his bills have been paid. I am unable to transfer his stocks and retirement account to my name. I have repeatedly checked the unclaimed properties list to no avail. No probate was required because the estate was too small. Will you please assist me with the steps I need to file to make this transaction occur?

Answer: Each state has its own laws for small estates and how to transfer assets, said Jennifer Sawday, an estate planning attorney in Long Beach.

In California, for example, a small estate is one with $166,250 or less in assets. If your brother’s estate was under this amount, you can complete a form that’s commonly referred to as a small estate affidavit and present it to the financial institutions or a stock transfer agent to start the transfer process. You can search online for a sample form or ask an attorney for help.

Q&A: Gift taxes vs. estate taxes

Dear Liz: A reader recently asked about passing a $500,000 inheritance to their children. You mentioned the option of disclaiming, or refusing the inheritance so that it would go to their kids. You wrote, “If you decide not to disclaim and later give the entire $500,000 to your kids, you wouldn’t have to pay gift taxes until you gave away considerably more. Plus, gifts are tax free to the recipients.” Are you possibly mixing up gifting and inheriting? As I understand it, gifting to your kids is limited to something like $15,000 per parent per kid. Unless you have a huge family, that’s not going to add up to $500,000 of tax-free giving.

Answer: Many people get confused about how gift taxes work. The gift and estate tax systems are intertwined, causing further confusion.

There’s no limit on how much you can give away during your lifetime: You can give as much money as you want to as many people as you want. If you give more than $15,000 to any one recipient in a given year, however, you’re required to file a gift tax return. That doesn’t mean you owe gift taxes.

The amounts over $15,000 count against your lifetime estate and gift tax exemption, which is currently $11.7 million per person. So if you give someone $20,000, the extra $5,000 would be deducted from your $11.7-million lifetime exemption. Only after you exhausted that lifetime exemption would you owe gift taxes.

Q&A: How to pass on inheritance to your children

Dear Liz: I may inherit $500,000 but do not necessarily need the money for my retirement. Is there a way to pass that inheritance, or a part of it, to my two children without incurring a taxable event for myself or for them? I may want to ask my parents to add that to their trust or will.

Answer:
You can “disclaim” or refuse to accept all or part an inheritance. If you do so correctly, the assets will pass to the next beneficiary as dictated by the estate documents (or by state law, in the absence of a will or living trust). If you think you’ll want this option, definitely discuss this with your parents and their estate planning attorney so the documents can be set up properly.

Keep in mind that few families have enough wealth to be affected by gift or estate taxes. Only people who give away millions of dollars in their lifetime have to pay gift taxes, for example. If you decide not to disclaim and later give the entire $500,000 to your kids, you wouldn’t have to pay gift taxes until you gave away considerably more. Plus, gifts are tax free to the recipients.

Gift and estate laws are always subject to change, so definitely consult a tax pro before making any decision regarding either.

Q&A: Who inherits when estranged spouse dies?

Dear Liz: I lost my husband a year ago. We had been married since 1997 but separated 10 years ago. Does the house belong to me or my 22-year-old son? Also, how do I find out if he had life insurance without being charged a lot? His girlfriend said he did.

Answer: The two most important factors here are whether you were legally separated and whether your husband made a will. If you were legally separated, there may have been an agreement approved by a judge that could affect how assets are divided. If the separation was informal, then the law typically treats you as if you were still married.

If your husband had a will, that would dictate who gets what. If he died without a will, then state law determines how to divide what’s left after his final expenses and creditors have been paid. When someone is married and has children with the current spouse, typically the entire estate would go to that spouse. Otherwise, half usually goes to the spouse and the rest is split among other heirs, such as children from another union.

This assumes the house wasn’t jointly owned with someone else, such as your son or the girlfriend. Property held in joint tenancy, tenancy by the entirety, or community property with right of survivorship will automatically pass to the other owner at death.

“Consulting with an attorney or trusted CPA, checking title to the real property and reviewing mortgage statements should be done to help determine their rights and how to proceed,” said estate planning attorney Jennifer Sawday of Long Beach.

If you would be the beneficiary and probate hasn’t been started, consider hiring a probate attorney to put that process in motion. The person settling his estate can look through his bills and other paperwork for evidence of life insurance, or you can try the life insurance policy locator maintained by the National Assn. of Insurance Commissioners.

Q&A: Should you sell a house or let heirs deal with it? The taxes shake out differently

Dear Liz: My mother, who will be 101 later this year, is leaving me real estate in her trust. The value of it is $4.5 million. She has other assets that will put her estate over $5 million when she passes. I currently have an offer from someone who wants to buy the real estate. Is it better for her to sell it now and reduce the value of her estate? She has never exercised the option for the one-time sale of her primary residence tax free. What are the tax implications if it remains in her estate until she passes?

Answer: There’s no such thing as a one-time option to sell a home tax free. Decades ago, homeowners could defer the recognition of taxable gain if they bought another house, and homeowners 55 and older could exclude as much as $125,000 of gain. That was a one-time deal, so perhaps that’s what you’re remembering.

Since 1998, however, taxpayers have been able to exempt as much as $250,000 of capital gains from the sale of their primary residence as long as they owned and lived in the home at least two of the prior five years. Taxpayers can use this exemption as often as every two years.

Clearly, your mom needs to find a source of good tax advice, such as a CPA or other tax professional. If you have the authority to act on your mother’s behalf through a power of attorney or legal conservatorship, then you should seek the tax pro’s advice as her fiduciary.

Under current law, if she retains the real estate it would get a “step up” to the current market value as of her death. That means all the appreciation that happened during her lifetime would never be taxed. If she sells now, on the other hand, she probably would owe a substantial capital gains tax bill, even if she uses the exclusion. The tax pro will calculate how much that’s likely to be.

That tax bill has to be weighed against the possibility that her estate could owe taxes. The current estate tax exemption limit is $11.7 million, an amount that will continue to be adjusted by inflation until 2025. In 2026, the limit is scheduled to revert to the 2011 level of $5 million plus inflation. President Biden has proposed lowering the limit to $3.5 million and modifying the step up, but those ideas face stiff opposition in Congress.

An estate planning attorney could discuss other options for reducing her estate if she’s still with us as 2025 approaches. The tax pro probably can provide referrals.