Should you do tax-related estate planning even if your estate won’t be big enough to owe estate tax?

Yup, you should, and I’ll explain how it could save your estate and/or your heirs some money.

It’s true that estate tax planning is, in a narrow sense, only for the very wealthy—those who will leave enough assets to be subject to federal estate taxes, which currently means a little more than about $11 million for an individual or $22 million for a couple. Further, some states have estate or inheritance taxes, but in many cases these are not significant enough to warrant serious and costly estate-tax planning. However, irrespective of estate taxation, there are still many income tax issues that the average “non wealthy” taxpayer could get stung by. Here are some of them…

Taxation of decedent. When someone dies, there typically is still some income to be received in his or her name that would be subject to tax. This would include interest and dividends on accounts still registered in their names as of the date of death, salary earned that hadn’t been paid as well as bonuses and business income. All of this has an official sounding name: income in respect of a decedent, or IRD.  This is any income that the decedent was entitled to upon his/her death that is received afterward.

IRD tax filing. The IRD amounts received would be kept track of separately, and a separate income tax return would be filed for this income. The return would be filed by the estate and would be on Form 1041, U.S. Income Tax Return for Estates and Trusts. Some deductions would be allowed, and the executor or estate representative would be responsible for the filing. If the IRD income were distributed to beneficiaries, the estate would get a deduction for that, eliminating the estate’s income tax, and the beneficiaries would be taxed on that income. This is generally an advisable strategy because while the estate’s income tax rates are the same as for individuals, the brackets are condensed so that estates get to the highest rates at a much lower amount of income than individuals.

Income received after death. Income that is not IRD but that was still in the decedent’s name and earned and paid after death is not IRD, but simply income, and this would also be reported on the estate’s income tax return as described above.

Retirement plan accounts. Generally, distributions from IRAs, 401Ks, 403Bs, pensions and any form of retirement accounts are IRD and will be subject to income taxation by the recipient. These accounts typically have a designated beneficiary and will bypass the estate and go directly to the beneficiary. Such amounts will be subject to taxation in the year received. In many cases, distributions can be delayed for many years, but whenever distributed, they will be taxed to the recipient. In situations where the estate is the beneficiary, the IRD filing rules would prevail. To avoid excessive taxation, any retirement assets should be carefully reviewed before any actions are taken. Note that not all distributions are IRD, for example, post-tax contributions are not IRD…and distributions from Roth IRAs and Roth 401Ks are not IRD since they are tax-free.

Capital gain income. Capital gains at the date of death are basically forgiven. This process is called the “step up in basis” rule. This means that any assets that would be subject to capital-gain taxation take on as the new tax basis the value at the date of death. Thus, inherited stocks, residences, art and collectibles, business ownership and similar assets will escape capital gain taxation when eventually sold by the beneficiary.

Life insurance. Proceeds from life insurance are income-tax-free regardless of who owned the policy. Note that if the policy was owned by the decedent and the proceeds are great enough, this could result in a taxable estate. The receipt of life insurance proceeds usually is delayed somewhat after the date of death and will include interest for that period. That interest would be taxable to the recipient. One possible exception on the life insurance front: cases where the transfer for value rule applies—when a policy was acquired from an original person taking out the insurance.

Annuities. This is a hybrid asset. If annuity income distributions are made, they would be treated as IRD and taxed the same way a retirement account is taxed. If the annuity pays a death benefit, that would be treated as life insurance proceeds and escape taxation except for any post-death interest. Any basis in the annuity contract (what was paid to obtain it) that is returned to the estate is not IRD.

Six-month alternate valuation rule. An estate can make an election to have all the assets valued at a date six months after the death. There are a number of reasons why this might be done, and this is a strategy that should be discussed with the attorney or accountant who is advising the estate.

Charity. Many estates provide for amounts to go to a charity.  This could be treated as a deductible amount on the Form 1041.  However, if there is no income reported by the estate, then there would be no income tax charity deduction benefit.

Trusts. Many people place assets in a trust. There are many types of trusts, irrevocable and revocable, and many tax-related reasons for establishing a trust that I will explain in future posts. One important precept to keep in mind, though, is this: If a revocable trust is established with the grantor as the trustee—a “living trust”—the trust’s assets would pass to beneficiaries upon the grantor’s death without going through the probate process, and the IRD taxation and stepped-up basis rules would apply to applicable amounts received or inherited as if they were in the decedent’s name.

Assets passing outside of the probate estate. Many assets pass outside of a probated estate. These include retirement accounts, life insurance, annuities and trusts mentioned above. However, it also includes anything that has a separate beneficiary, and the taxation rules above apply to all of this. Further examples include “payable on death” accounts, joint accounts, certain stock options and restricted stock or anything where a beneficiary can be provided for.

Final tax return. All of the decedent’s income and deductions up to the date of death are reported on that person’s final tax return along with the full year of the surviving spouse’s income and deductions, if any. If the decedent filed joint returns, then a joint return would still be filed for that year, but the income and deductions for the decedent would be cut off as of the date of death.

Surviving spouse. A surviving spouse with a dependent child can continue filing tax returns using the advantageous joint tax-rate table for two years after the date of death. Note that capital loss carryforwards and other carryforwards that were in the name of the decedent disappear, so it might be appropriate to do some pre-death carryforward planning in cases where carryforwards are substantial—check with your tax advisor.

The above are some of the income tax consequences that need to be adhered to when someone dies. With all of the above, as with any complicated tax matter, it is best to seek the advice of an estate planner or other qualified tax professional with knowledge of your particular situation.

For more information, check out Edward Mendlowitz’s website, or click here to purchase his book, Managing Your Tax Season.

Related Articles