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Estate taxes

Dear Dollar Diva,
If I inherit some money, what is the tax rate I would have to pay on it?
Miriam

Dear Miriam,
As a general rule, the tax rate on inherited property, including money, is zilch; you don't even have to report the event on your tax return. However, once you own the property, any income earned on it becomes taxable.

 

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One notable exception to this tax-free rule is the inheritance of an Individual Retirement Account (IRA). The IRS handles each type of IRA differently; the Diva gives the highlights of inheriting Roth and traditional IRAs below, but first, she wants to mention estate taxes.

You generally don't pay tax on inherited property, because any tax that's due is paid out of the decedent's estate before the property is distributed. The estate tax, also known as the "death tax," adds insult to the injury of dying; depending on when you die and how much you leave behind, the insult can go as high as 55 percent. 

Estate tax law is very complex, but ignoring its ramifications could cost your heirs a bundle. If your net worth is a million bucks or better, and you'd rather leave it to your grandchildren than Uncle Sam, ring in the New Year by setting up an appointment with an estate tax professional. 

Here are the estate tax exemption amounts from 2002 through 2011:

Year

Estate tax exemption

2002-2003

$1 million

2004-2005

$1.5 million

2006-2008

$2 million

2009

$3.5 million

2010

Estate tax repealed

2011

$1 million

Inherited Roth IRA
The Roth IRA is funded with after-tax dollars, and those dollars are never taxed again, no matter when they're distributed. If you inherit a Roth IRA that is at least 5 years old, all distributions -- including income and capital appreciation -- go to you tax-free.

The bad news: The very first Roth IRA account was born in 1998, and will not meet the five-year holding period until Jan. 1, 2003.

The good news: You don't have to take the money the minute you inherit it. There's a "five-year rule" that says you don't have to take distributions from an inherited Roth IRA until Dec. 31 of the fifth year following the year of death. That's more than enough time to meet the five-year holding period, and take your distributions tax-free.

For other distribution possibilities, read IRS Publication 590, Individual Retirement Arrangements (IRAs).

Inherited traditional IRAs
The traditional, tax-deductible IRA is funded with tax-free dollars; the tax gets paid in the future, when distributions are made to the owner or beneficiary. Expect distributions from this type of IRA to be taxed at your marginal tax rate, or higher.

It's usually smart to spread out the distributions as long as you can. You'll have the advantage of tax-deferred earnings and there's less of a chance of getting bumped up into a higher tax bracket. You should be able to spread out the distributions anywhere from five years to your life expectancy; IRS Publication 590 spells out the rules. It will also give you the rules for traditional nondeductible IRA distributions.

When a spouse inherits an IRA
You've probably heard about the "marriage penalty" built into the tax code, but there's a marriage benefit when you inherit an IRA from your spouse.

You can make the IRA your own and keep it growing, tax-free or tax-deferred, until you're required to make distributions. Just call the account representative at the financial institution holding the IRA and ask what you have to do to have yourself removed as "beneficiary," and designated as "account owner." This is particularly nice when the IRA is a Roth; it can grow tax-free for as long as you live.

U.S. savings bonds
You might have to pay tax on the interest on inherited US savings bonds; it depends on how much of the tax the decedents paid during their lifetimes and on their final tax returns; IRS Publication 550, Investment Income and Expenses, spells out the rules.

To learn more about inheritances, including which items are taxed and which are not, read IRS Publication 17, Your Federal Income Tax for Individuals.

DOROTHY ROSEN has a master's degree in finance, with a specialization in accounting, from the Kellogg Graduate School at Northwestern University in Evanston, Ill. Rosen has more than 15 years of experience in the financial arena, serving in Illinois and Florida as a certified public accountant, financial consultant, expert witness and educator. She is owner of Dorothy Rosen, CPA, a public accounting firm that serves individuals and small businesses.

 
-- Posted: Jan. 3, 2002
   

 

 
 

 

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