Listen to Scott and Pat explain how probate taxes work, what a "step-up in basis" is, and what other types of taxes may come into play when someone inherits assets.

Read Full Audio Transcript

Pat McClain: And let's talk to Marjorie.

Scott Hanson: Marjorie, you're with Hanson McClain's Money Matters. Thank you for waiting.

Marjorie: Thank you. I would like to know what you know about probate taxes. I am still waiting, year and almost a year and a half now. It looks like it might come to a conclusion next month. And I wondered what kind of taxes I'm looking at.

Pat McClain: Oh, got it. Got it. Let's talk about the estate that you are inheriting.

Scott Hanson: Or you're the trustee on...

Marjorie: It's not very much.

Pat McClain: How much is it?

Marjorie: I don't really know. I haven't, I don't really know. I assume that I probably will get I don't know, $30,000-40,000 that's just probably. That's all I'm counting on.

Pat McClain: Okay.

Marjorie: If I get more I'll be happy.

Pat McClain: So there won't be any estate tax...

Scott Hanson: If you're not, you're not involved in the dissolution of the estate here. You're not involved in the probate.

Marjorie: No my sister is in charge of that.

Scott Hanson: Okay.

Marjorie: With the attorneys and so forth and I don't get a lot of information.

Pat McClain: Okay, so we'll walk you through a couple things here.

Scott Hanson: There is no Federal death tax. There is what's called an estate tax, but the estate tax is not triggered until an estate is worth over $5 million dollars. It's about 5 point...

Marjorie: Oh, we don't have to worry about that then do we?

Scott Hanson: That's exactly it.

Pat McClain: At least that tax. There are a couple things you could be taxed on.

Scott Hanson: Here's where we oftentimes we see them. One is if someone inherits a retirement account, like a 401K or an IRA.

Pat McClain: Or a 403B.

Marjorie: Yeah, there might be one of those.

Scott Hanson: Okay, so that where it's going to be taxed is when you take the money out of the plan, that's when you'll pay taxes on it.

Pat McClain: And in most circumstances, you have to take that distribution based on your life expectancy and you need to start it the first year that you receive the dollars. If you miss the first year, then you have to take it out of a 5-year period. Depending upon the size of it and your income tax bracket, you may decide to defer it or you may decide to take it all at once, it just depends on your particular situation and your marginal tax bracket.

Scott Hanson: Yes, because the tax on an inherited in an IRA could be anywhere from zero to 39.6% federal. Plus 3.8% Obamacare tax, depending on the other end. It's not going to be that high for you because you're just not that large of a...

Pat McClain: Well, depending upon your income tax bracket.

Scott Hanson: I'm assuming you're not several hundred thousand.

Marjorie: I'm an old lady.

Pat McClain: Well we'll be the judge of that.

Marjorie: Yeah, okay.

Scott Hanson: The second thing is where we see them is where people inherit annuities. So, if there was an annuity purchase maybe at the bank, taxed differed annuity, all that gain inside that annuity will be taxed to the beneficiaries.

Marjorie: Okay.

Pat McClain: Or savings bonds.

Scott Hanson: Saving bonds as well. You have saving bonds.

Pat McClain: Pretty much everything else will receive a step-up in basis, or will have no taxes due on it on an estate this size. Those are the three things that you may have some tax liability and all three of those you have control, some control over when that tax liability is going to come to you.

Marjorie: I see, I see. Alright, that sounds...

Pat McClain: If the estate is $40-50 thousand dollars...

Marjorie: Well the estate is more than that but there are four of us and my part would be that amount. I assume.

Pat McClain: If you're not in a high marginal tax bracket at this time...

Marjorie: I am not.

Pat McClain: I would probably just tell you cash it all out as quickly as possible and just move on and it will make it easier in terms of...

Marjorie: Exactly, exactly.

Pat McClain: Easier and less expensive in terms of tax preparation.

Marjorie: Okay.

Pat McClain: All right?

Marjorie: Very good, yes. Thank you very much.

Scott Hanson: I appreciate...

Marjorie: You're very, very sweet, both of you.

Scott Hanson: Why thank you.

Pat McClain: Thanks, Mom. Glad you called. I've been looking for that my whole life. Thank you. Isn't that cute? That's sweet. Yeah, I've been looking for that for a long time.

Scott Hanson: Looking for that, seriously, a couple notes on here before we go back to calls. Most of us are going to die, leaving assets to other people, that's the reality. Unless you know the exact day you're going to die, you'll probably have some assets, some assets that are going to be left on. And as your estate gets larger, it's actually pretty important to start thinking about which assets, from a tax standpoint, are best to leave. When you look at something like, if somebody owned something outright whether it's a mutual fund, a stock, a piece of real estate, any sort of other asset, whatever gain has occurred during that person's lifetime, that gain when someone passes away and it's left to an heir, and that person inherits that asset, from a tax standpoint, the cost basis, what the person had paid for that asset originally gets stepped up to the fair market value on the date that person passes away.

Pat McClain: Unless, so I had this situation that happened recently. Which is, someone gifted, gave, the mother gave the property to the son and I said, "Oh that's probably a mistake."

Scott Hanson: Bad.

Pat McClain: Well the father had died the year before and had received a full step-up in basis at that point in time.

Scott Hanson: It kind of worked out.

Pat McClain: It kind of worked out.

Scott Hanson: If you inherit an asset from a tax standpoint, you inherit that asset with cost basis equal to the fair market value, the day that person died or sometimes for larger states they'll use an alternative date.

Pat McClain: Alternative date. For most of America, it's the day they die.

Scott Hanson: That's correct. But, let's say that somebody on their death bed said, "Oh, Billy, I've always wanted you to have this thing, this stock, this piece of property...

Pat McClain: This house.

Scott Hanson: And it's gifted on one's deathbed. That might sound well and good. The challenge is, you're no longer going to have that same tax break, the stepped up basis, the forgiveness of that capital gain. Because when someone gifts an asset to somebody else, that cost basis transfers forward. So the person who then receives that gift has a cost-basis, just like the person, whatever they paid for it originally.

Pat McClain: You think the reason people are gifting it rather than waiting to inherit is because they believe that that they will avoid the hassle of probate. Well, that's true, in some cases. It's actually a lot less expensive and easier to put it in a trust and although there's a cost to a trust normally is much less than the gain. The only reason you would gift something is...

Scott Hanson: You wanted it out of your estate for some other reason.

Pat McClain: Yeah, it's cost basis.

Scott Hanson: Or through some other planning, let's say you have a business.

Pat McClain: Yeah, but for most Americans you're better off to inherit the asset.

Scott Hanson: Yes.

Pat McClain: Rather than to have it gifted to you.

Scott Hanson: Now retirement plans, IRAs, those when whoever inherits the IRA is going to have to pay tax based upon their tax rate. So you inherit someone's IRA, you'll be taxed, withdraws, your tax rate. So I'll give an example. I've got some clients I'm working with right now, they've done a good job saving, they have a relatively large IRA balances. Their kids, they have 3 kids, all have done phenomenally well economically anyway. And I'm sure their personal lives are disasters.

Pat McClain: But they do it in really nice houses.

Scott Hanson: Well because there's more to life than just finances.

Pat McClain: You have to profess that economically.

Scott Hanson: I was going to say, they've all done very well economically and are all in very high tax rates. So from a planning standpoint it was like, we're trying to drain down their IRAs because they're in a lower tax bracket now.

Pat McClain: So mom and dad drained the money, paid the taxes, invest in something that's tax efficient, where it'll receive a step-up in basis at death and more assets-net of taxes than go on to the children...

Scott Hanson: They're both in their late 80s, they know they're not going to live forever. That makes perfect sense. Same thing with annuity contracts.

Pat McClain: Let me ask you a question, Scott. Having that conversation with a client, is a hundred percent opposite what you would normally everything they were taught about tax-deferrable, or they learned, or they heard, and tell me someone to take the money before you have to pay taxes on it, was it a tough conversation?

Scott Hanson: They have an annuity that they've purchased, they've been clients for maybe 20 years. They had an annuity contract they purchased prior to me. Having this conversation now, I'm trying to get the same thing because I said, "Look this taxation is going to be hitting the beneficiaries."

Pat McClain: They're a higher tax bracket than you.

Scott Hanson: Annuities and IRAs, bad assets, relatively bad assets to leave to heirs because of the tax stuff.

Pat McClain: But they're great to leave to charities. If you have a charitable intent, holy smokes there's no better asset to leave to a charity than an IRA.

Scott Hanson: Or annuity because all that gain that's occurred, that's going to be taxed to your beneficiaries at ordinary income rate, non-profits don't pay taxes.

Pat McClain: No better asset to give to a charity.

Scott Hanson: So they work out fantastic, and that's why sometimes when you look at. All this estate planning, it's really important to look at these different assets and as we're getting up in age saying, "Where should we be drawing our income from?" and sometimes as you said Pat, the wisest thing to do is not do the lowest taxable income today, it's going to be what's going to be lowest taxable, lowest overall tax for your beneficiaries, the overall estate.