Daniel Ruske, CFP®, Author at Peterson Wealth

Do I Have to Pay Taxes on an Inheritance?

Posted on October 6, 2023November 8, 2023 by Daniel Ruske, CFP®

Over the course of the relationship with our clients at Peterson Wealth Advisors, it is inevitable that we get to guide the families of our deceased clients through the financial maze of settling an estate. Whether it is the passing of a parent, spouse, or other family member, beneficiaries often question: if, how, and when, the assets they inherit will be taxed. The goal of this blog is to give you a basic understanding of how various types of inheritance are taxed.

Does Utah have an Inheritance Tax?

State inheritance taxes vary widely across the United States. Some states impose an inheritance tax on assets received by heirs, while others do not. The rates and exemptions also differ significantly from one state to another. For instance, Utah is a state that does not impose an inheritance tax. This means that when individuals pass away and leave assets to their heirs, there is no state-level inheritance tax applied in Utah. There are a few states that do have an inheritance tax. It’s essential for individuals to be aware of the inheritance tax laws in their specific state.

Taxes on Inheriting Traditional IRA or 401k Accounts

One category of assets we see is a traditional IRA and 401k accounts. The money in these accounts have been tax-deferred for the life of the original owner, which means income tax has not yet been paid. There are different rules on how a traditional IRA and 401ks are treated at death depending on who is listed as the beneficiary. I will break it down below.

Spousal Beneficiary

If an IRA holder passes away and has his or her spouse listed as the 100% beneficiary on the account, the beneficiary has the choice to:

Own IRA – Transfer the decedent’s IRA to their own IRA. Doing this causes no immediate tax consequence and the survivor can then distribute the assets as their own. Taxes are paid on any distribution from the account in the year they are taken. Penalties apply to these distributions if the survivor is under age 59.5 and not eligible for an IRS exception.
Life Expectancy Beneficiary IRA – Transfer the decedent’s IRA to a Life Expectancy Beneficiary IRA (also called Inherited IRA). This option allows the beneficiary to avoid penalties on withdrawals if they are under the age of 5 but requires an annual distribution or Required Minimum Distribution starting either the year after death or the year the original owner would have turned 73, whichever comes later. Required distributions will be covered in more detail below. There is no tax due on the initial transfer from decedent to beneficiary.
10-Year Beneficiary IRA – Transfer the decedent’s IRA to a 10-year Beneficiary IRA (also called Inherited IRA). This option also allows the beneficiary to avoid penalties on withdrawals if they are under the age of 5 but has requirements to distribute the account before the 10^th year as further described below.
Distribute the Account – With the three options above, there is no immediate taxable event on the transfer of assets. In this option, a spouse listed as a beneficiary of an IRA account liquidates all the money in the IRA and pays taxes on 100% of the account balance in the same year. This is typically only recommended on IRAs with smaller account balances.

When selecting which option is best for you, make sure to be mindful of your tax bracket to avoid a large tax bill in a single year. Consider consulting a financial or tax professional for assistance.

Non-Spousal Beneficiary

If an IRA holder passes away and has a non-spouse listed as the beneficiary on the account, the rules are different than when the spouse is listed. The non-spouse beneficiary cannot transfer the account to their own IRA. The assets must be transferred into a new account called a Beneficiary IRA or also called an Inherited IRA. This is very common when a parent passes away. There is no tax due at the time of inheritance if these funds stay in an IRA. However, the IRS does have Required Minimum Distribution (RMD) rules on beneficiary IRA accounts that are different from the RMDs for the original owner.

If the original owner of the IRA passed away before January 1, 2020, then there will be an annual required distribution that increases each year until the account is fully liquidated. Accounts following this RMD schedule will continue to become less common as 2019 becomes further in the past.
If the original owner passed/passes away on or after January 1, 2020, then the 10-Year Rule applies. The 10-Year Rule states that the owner of the Inherited IRA has no yearly mandatory distribution, but they must withdraw 100% of the account by December 31^st of the 10^th year after the original owner died. Distributions from an Inherited IRA are taxed as ordinary income.

Certain exceptions can apply to eligible designated beneficiaries which may allow additional flexibility to the RMD rules. An eligible designated beneficiary is a minor child, someone who is chronically ill or permanently disabled, and individuals who are more than 10 years younger than the original owner.

Taxes on Inheriting Roth IRA Accounts

Inheriting a Roth IRA account is very similar to a Traditional IRA account. The rules regarding Roth accounts vary depending on the type of beneficiary and required distributions do apply. However, distributions from a Beneficiary Roth IRA (also called Inherited Roth IRA) are tax-free assuming the 5-year rule has been met.

Taxes on Inheriting a Home, Real Estate, and Other Non-IRA Investment Accounts

It is common for decedents to leave non-retirement assets to their beneficiaries. The most common types of non-retirement assets include individual investment brokerage accounts, joint investment brokerage accounts, and real estate.

To understand the taxation of non-IRA assets you must first understand what the term “cost basis” means. Cost basis refers to the portion of an asset you own that has already been taxed. For instance, if John purchased a stock in his individual brokerage account for $100,000 and it grows to $125,000, John’s cost basis is $100,000 and his capital gain is $25,000. If John sold this asset, a capital gain tax would only be owed on the $25,000 gain and not on the original $100,000 basis.

Under current law, at the death of the owner of a non-IRA asset, the value of the account receives what is called a “step-up in basis.” This means that any growth (or losses) that have occurred on the asset reset to the fair market value of the asset at the date of death. For example, if John invested $100,000 into an individual investment and it grew to $125,000, his cost again would be $100,000. However, if John passed away without selling the asset, at John’s death his cost basis is “stepped-up” to $125,000. John’s beneficiaries will not have to pay capital gain tax on the $25,000 gain.

The step-up in basis differs for married couples holding property jointly depending on what state you live in. However, in general, the following rules may apply: There are community property states and non-community property states.

Community Property States:

Community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

When one spouse dies, the asset typically receives a full step-up in basis to its fair market value at the date of the deceased spouse’s death. This means that the surviving spouse’s share and the deceased spouse’s share both receive a step-up on the basis.

For Example: John and Jane jointly own an asset in a community property state. They bought the asset years ago for $500,000 and it is now worth $1,000,000. If John passes away, the full value of the asset would be stepped-up to the fair market value. Jane’s new basis on the asset is $1,000,000 and she could then sell the asset with little to no tax impact.

Non-Community Property States:

In non-community property states, the step-up in basis rules are different from those in community property states. For instance, if the property is held in joint tenancy, the step-up in basis applies only to the deceased owner’s share. When one owner dies, their share of the property receives a step-up in basis to the fair market value at the date of death while the surviving owner’s share retains its original basis.

For example: John and Jane jointly own an asset in a non-community property state, if John passes away, only his 50% share receives a step-up in basis to its fair market value at the date of his death. Jane’s 50% share retains its original basis. Jane’s new basis on the asset is $750,000. However, it is important to note that Jane now holds the asset individually and will receive a step-up in basis on the full value at her death.

In my experience, in both community and non-community property states, beneficiaries pay little to no tax on the inheritance of real estate because the basis is stepped up to the fair market value at the date of the second spouse’s death.

Step-up in basis rules can change over time and tax laws do vary. Please consult an attorney specializing in estate planning and tax matters to understand the specific implications and requirements in your situation.

When does estate tax apply?

Estate tax, also called inheritance or death tax, is imposed on a deceased person’s estate before assets go to heirs. It is calculated on the total value of their assets, minus deductions, and exemptions. 99+% of estates do not pay federal estate tax. However, if your estate exceeds the applicable estate tax exemption threshold, your estate may be subject to estate tax. The exemption laws and amount of the exemption changes over time.

However, the federal estate tax exemption for 2023 is $12.92 million per person, which means that for a married couple, their exemption is over $25 million. If the total value of the estate, including assets such as property, investments, and cash, exceeds the exemption, the estate may owe estate taxes on the amount exceeding the exemption. It is extremely rare for estates under the threshold to pay estate taxes.

Conclusion

As you can see, there are many ways that inheritances are treated when being taxed. It is important that the beneficiaries understand all the tax liabilities associated with their inheritances and then formulate a plan to reduce the tax burden in their own situation. We find that clients are usually relieved to hear that in most cases there is no initial tax bill due to receive the inherited assets and that they have several options available to distribute retirement assets at a later date.

If you have any questions or concerns about your specific financial circumstances, do not hesitate to contact Peterson Wealth Advisors. Our team is dedicated to helping you find the best solutions to meet your financial goals. Additionally, if you require additional support with estate or tax planning, we can connect you with qualified professionals who can help you with your needs.

Note: The information applies to individuals listed directly as the beneficiary on decendent’s accounts. If a trust or estate, consult an estate planning attorney for the taxability of those assets. This post is not intended to be tax or legal advice. Please consult a professional for your specific situation.

The Role an Emergency Fund Plays for Retirees

Posted on September 29, 2022May 10, 2023 by Daniel Ruske, CFP®

An emergency fund is a portion of money set aside to be used as a buffer in the event of an emergency or for an unforeseen expense. During the accumulation phase of life, or the years in which a household is reliant on a paycheck and actively saving toward retirement, an emergency fund provides a safety net to balance the budget during events such as loss of work, an expensive medical bill, or a car repair. In every personal finance textbook, you will find details on how to best manage an emergency fund. However, most of these texts focus on the accumulation phase of life. They aren’t focused on applying these beneficial principles to retirees. So, let’s go over the details of an emergency fund for retirees.

How much should I have in an emergency fund?

There is a rule of thumb that is used when determining how much a household should have in an emergency fund. The guidance is to have at least three to six months’ worth of expenses set aside. This can be a good benchmark to measure yourself against. But the problem with a rule of thumb is that everyone’s individual situation is different and may require more customization.

Calculating an emergency fund during retirement is different than during accumulation. For instance, the risk of losing your job when you’re retired is zero percent. However, in most cases, this does not completely eliminate the risk of income loss. You must determine, based on your own cash flow risks, what amount is right. For example, a retiree with multiple rentals and a history of renter turnover will require more cash on hand than a retiree whose only income source is from Social Security and a steady pension.

Where should you invest your emergency fund? How much cash should I have on hand?

The goal of an emergency fund is not to earn the highest return possible. It is to have the funds accessible when needed. A common place for an emergency fund to be kept is in a savings or money market account. You can do this at your preferred bank or credit union. Online banks that pay higher interest rates can also be a good choice. Any of these options will work, as long as your money is easily accessible.

Do not keep your entire emergency fund in hard cash. Having a limited amount on hand in your home is reasonable. However, there are added risks in having large sums of cash in your home.

Investing excess savings

Once you have determined the amount for a comfortable emergency fund, you may need to add or subtract from your current account. If you need to increase your emergency fund, the best way to do this is by adding a portion of your monthly income to the fund until you have the desired balance. Anytime you use your emergency fund, immediately work toward increasing it back to the desired amount.

It can also be common for retirees to accumulate large sums of cash in savings accounts. These are much greater than an adequate emergency fund requires. During the accumulation phase, the guidance is to put 15 – 20% of our income away into savings. In retirement, this mindset changes. Keeping extra savings in the bank, in excess of your emergency fund, can be a missed investment opportunity. This will hamper your ability to keep your investments up with inflation. If you have a balance in your bank account on top of your emergency fund needs and what you might reasonably spend in a short period of time, consider investing these funds for a greater opportunity for growth. You should also consider reducing income from sources such as taxable retirement accounts to avoid paying taxes on this unspent income just to have it accumulate in the bank.

A good question to ask yourself if you are in this situation is “when do I plan on spending this money?” If it is more than five years out, investing the funds in a diversified portfolio will result in greater growth opportunities. Talk to your advisor to determine the right investment allocation.

Conclusion

Though the amount and use of an emergency fund slightly change for individuals moving from the accumulation phase to the retirement phase of life, it is still an important part of a retiree’s financial household. Having too little or too much in savings for a rainy day could cost you thousands of dollars over the course of your retirement. Talk to one of Peterson Wealth Advisors’ Certified Financial Planners with your questions about an emergency fund for retirees.

How Tax Withholding Affects Your Tax Refund

Posted on February 23, 2022March 9, 2023 by Daniel Ruske, CFP®

Every year, around March and April, we begin to hear people talk about the big plans they have to spend their anticipated tax refund. Some plan vacations to various destinations around the world, others plan to pay off debt, or add to their savings. All too often, this anticipated windfall turns into an unwelcomed tax bill to the IRS.

We have found that many individuals may not know what goes into calculating their yearly income taxes and why they may or may not get a tax refund. This article will serve as a simple reminder of the fundamental components that determine your tax refund.

What are Tax Refunds?

Tax refunds are not gifts from the government that you receive for filing your taxes. They are a return of your dollars that you have overpaid in taxes during the year. In most cases, when you receive some form of taxable income whether it be from a pension, Social Security, or a distribution from a retirement account, a portion of your payment goes directly to the IRS, or toward paying your state income taxes. This is known as withholding. You, the taxpayer, controls how much of your payment goes towards paying the IRS and the state. Due to tax deductions, tax credits, or a miscalculation, a household may over or under withhold the required yearly income tax they owe. An over payment of taxes will result in a tax refund, and an under payment will result in owing a tax liability. So, you, not the IRS or your state government, decide whether you get a refund each year because you determine how much is withheld from each paycheck.

The amount of your tax refund or liability received at the end of the year is not a good indication of your total yearly income tax liability. For example, a large refund does not mean your taxes are low, and having to write a check to pay state and federal tax does not mean your taxes are high. Receiving a refund or paying a liability is a reconciling of the income tax dollars you are required to pay.

Tax Withholding

Tax withholding can be adjusted on income from Social Security, pensions, distributions from IRAs, and salaries. You can also make an estimated quarterly payment directly from your checking account. So, if a person is looking for a large tax refund, they should increase the amount of taxes that are withheld throughout the year and the IRS will return it to them in the form of a refund.

Does it Matter if I Over-withhold or Under-withhold?

In most cases, the goal is to withhold taxes in the amount that will result in as small of a refund, or tax liability as possible. However, incomes, salaries, and laws can all change throughout the year making it difficult to achieve the goal of a net zero tax refund or tax liability. So, is it better to overpay taxes during the year and get a refund? The answer… it depends. It comes down to preference. Individuals who prefer to receive a tax refund check during tax season should look to over-withhold. Individuals who prefer to have extra cash throughout the year, even if that means paying a tax bill come tax time may prefer to under-withhold.

There are two extremes that help explain the concept of withholding and tax refunds.

Under-withholding: A couple has a taxable income of $81,050 in 2022 and withholds nothing. Their paychecks will be higher throughout the year, but when they file their taxes, assuming no penalty applies, they will owe a federal tax bill of $9,315.
Over-withholding: A couple has the same taxable income of $81,050 in 2022 and withholds $14,315. Their paychecks throughout the year will be lower since a higher portion is going to tax withholding. Instead of owing $9,315 at the end of the year, they will receive a refund of $5,000 because they over withheld.

It is important to understand that, assuming no under-withholding penalty applies, over or under-withholding taxes throughout the year does not result in a larger or smaller total tax liability. The only difference is the timing of when the taxes are paid.

When do Underpayment Penalties Apply?

You may be thinking, “Well if the timing of my tax payments doesn’t impact the amount of total tax I pay, then I won’t withhold anything all year and invest the tax payments in a high yield investment account. I can then pay my full tax bill at the end of the year and keep the interest I earn.” This can be a reasonable strategy assuming two things. First, you don’t lose money in your investment over the course of the year, and second, you don’t pay more in underpayment penalties than you make in interest. In most cases, you can avoid an under-withholding penalty if you withhold at least 90% of the tax due for the current year, or if you withhold 100% of the previous year’s tax liability.

You Owe What You Owe

Whether you are looking for a tax refund, or you prefer to not give the government an interest free loan and plan on paying your tax liability every April, you can rest assured knowing that as long as you satisfy the minimum withholding requirements, your total tax obligation will be the same.