This week, Gail offers some advice on inheritance — and their tax and IRA implications.
My friend's father passed away 2 years ago and she will be receiving $72,000 from her sister (who lives in their father's home) to settle the inheritance. Her sister will keep the house and pay off their father's debts. The money will come from a bank loan against the house.
My friend assumes the bank will write the check to her sister ($150,000 to cover their father's personal debt, and the portion owed to my friend). My friend would then receive a personal check from her sister. Would she be taxed on this money? Is it still an inheritance? If so, is there a tax? Would it be a gift?
Dear Norma —
When we receive something of value from someone while they are alive, it is considered a "gift." Every year, each of us is allowed to give a $10,000 gift to as many people as we want. In other words, I could give each of my 4 children $10,000 worth of stock each year and not owe any gift tax. However, if the gift is worth more than $10,000, then the giver — not the receiver — owes federal gift tax on the amount in excess of $10,000. To continue my example, if I gave all the stock to just one child in a single year, I would be liable for gift tax on $30,000 ($40,000 minus $10,000).
Because your friend received this property (the house) from her father after his death, it is clearly not a gift. Instead, it is an "inheritance" — an asset that passes to someone else when the original owner dies.
In order to "clean up" the affairs of a deceased person, it is necessary to settle any outstanding debts they might have. This includes any estate tax which might be due. Just as with the gift tax, this is the responsibility of the donor — not the recipient of the asset. So technically, her father's estate is responsible for any estate tax due. (However, often the decedent stipulates in the will that if estate tax is due, each beneficiary is responsible for paying his/her proportionate share out of the assets they inherit.)
Based on the law in effect two years ago, an individual could leave up to $625,000 worth of property to non-spouse beneficiaries and not owe any federal estate tax. Assuming the value of her dad's property at his death was less than this, there would be no estate tax due.
After paying funeral expenses, outstanding taxes and any debts the deceased person had, the remaining assets are then divided among the beneficiaries. Essentially, your friend's sister is buying out her share of their father's house, presumably because she wants to be the sole owner.
However, it would be a good idea to have this in writing. To avoid potential problems later on,there should be some type of agreement drawn up in which your friend states she is giving up her half-interest in their dad's home in exchange for receiving $72,000.
There is no income tax on inherited assets. Capital gains tax only applies when property is sold. At some point in the future, if her sister sells the house, the sister might owe capital gains tax on it. "Inheritance" tax is levied not by the federal government, but by the state in which we live. And, as is the case with the federal estate tax, there's usually a certain amount that you can inherit before inheritance tax kicks in. This varies by state, so your friend ought to speak with a local attorney. If there's a law school nearby, they might offer free legal aid, compliments of third year law students.
I hope your friend gets some advice on what to do with this money because if she doesn't fritter it away, she'll end up with a tidy sum. For instance, let's assume she is in the 25% tax bracket (coming in a few years) and that her $72,000 is in an account that earns 8% a year, compounded annually. In 20 years — after taking taxes from the earnings each year — she'll have $247,356. If she invested it in a tax-deferred account that had the same annualized return, she'd end up with almost $100,000 more.
Best wishes —
P.S. The recent tax law is complex and subject to change, so it's important to remember that these numbers are for illustration only and may or may not be realized.
Dear Gail —
My 68-year old aunt passed away earlier this year, leaving me her IRA worth $86,000. Do I owe taxes on this? I'm 45 years old. Can I leave the money in her IRA until I'm 70 1/2?
Dear Jay —
Only a spouse who inherits an IRA has the option of leaving the money in the account until they reach age 70 1/2, the so-called "required beginning date" for mandatory IRA withdrawals. A non-spouse, such as yourself, must begin making withdrawals from the IRA by Dec. 31 of the year following the IRA owner's death, no matter what their age is. Since your aunt died this year, you have until the end of 2002 to meet this requirement.
While you are certainly free to completely clean out the IRA, any withdrawals you make are subject to income tax. Since it sounds as if you don't need the money, your best strategy is to just take out the minimum amount required. Next year you would calculate your first withdrawal by dividing the value of your aunt's IRA at the end of this year by your life expectancy, conveniently provided by the IRS in Publication 590. You can access this on-line at http://www.irs.gov. A 46-year old (your age when you start withdrawals next year) has a life expectancy of 36.8 years.
Let's say your aunt's IRA is worth $90,000 on Dec. 31, 2001. The minimum you are required to withdraw next year would be $2,436 ($90,000 divided by 36.8). In 2003, you'll be a year older, so your life expectancy will drop by one year, meaning your divisor that year will be 35.8 and so on.
If your aunt's IRA is the traditional, tax-deductible kind, you will owe income tax on each year's withdrawal. However, you might even get a break here if estate taxes were paid on the IRA when she died, so talk with a competent tax professional. On the other hand, if your aunt converted her IRA to the Roth variety before she died, then every cent you withdraw is income tax-free.
I know it's tempting to go crazy and spend a windfall like this, but it really pays to be patient and stretch out the IRA over your own life expectancy.
Take it slow,
If you have a question for Gail Buckner and the Your $ Matters column, send them to firstname.lastname@example.org along with your name and phone number.
The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.