On death, taxes, and the "death tax"
Let's get this out of the way first: I hate the phrase "death tax". "Death tax" makes it sound like the Big Bad Federal Government taxes everyone's poor mother, just to make sure nothing goes to the long-suffering children. No. Just no.
The phrase "estate tax", on the other hand, conjures up images of millionaires sitting in their mansions. And it should! As of 2019, the federal estate tax only applies to folks who pass away with over $11,400,000 in net worth -- and effectively $22,800,000 if they're married!
So if you were worried about the estate tax, you likely needn't be. Do pay attention to what your state does, though. (Unsurprising spoiler: Texas has no estate tax.)
Having said that, even if (like literally 99.9% of Americans) you fall below the threshold, you're not completely out of the woods. The estate tax isn't the only thing that can take a bite out of an inheritance!
"Probate" is just the legal term for the process by which the will of the person who died is proven and executed, but as with anything having the word "legal" in it, it can be expensive and/or time consuming. There are two aspects to consider here: your executor, and the court process itself.
As far as executor fees go, you've generally got some significant flexibility there -- you can actually specify the fee in your will itself! Moreover, if the executor also happens to be your only beneficiary, well, why take a (taxed!) fee at all? That said, each state generally has its own rules as to what is "customary", and these rules come into play (a) you don't specify a fee, or (b) the executor petitions to have it changed.
And like customary executor fees, each state also varies in terms of its probate court process. Some states (Texas!) are streamlined and cheap, while others (California!) are...not.
Now, remember that when you die, not all of your assets go through probate! If you have an account that's "joint tenants with rights of survivorship", that "rights of survivorship" bit means that the the account bypasses probate. Same thing with retirement accounts and life insurance policies: the proceeds go to the beneficiary listed in the account or policy, do not pass probate, do not collect $200, etc. etc.
And if you really hate the idea of any of your assets going through probate, you can set up what's called a "revocable living trust": basically, while you're alive, you can put whatever assets you want into a trust that you control. According to the law, assets held in trust also bypass probate, so this can provide an end run around probate.
But before you run out and set one up, note a few things: (1) living trusts require a lawyer to set up, so they ain't free, (2) you have to actually put the assets in the trust, which can be a one-time and ongoing hassle, and (3) the trust bypasses your will, so you need to make really sure that it's set up the way you want it!
Yep, another financial TLA (Three-Letter Acronym). "IRD" stands for "Income in Respect of a Decedent" -- basically, income that the person who died hadn't actually gotten yet. Now, there are a raft of assets that can fall into this category, like final paychecks and installment sale gains, but most of them fall squarely into the "it is what it is" category: not much planning to be done for them.
However, there is one IRD asset worth pondering: pre-tax retirement accounts, like Traditional IRA's and Traditional 401(k)'s. As you no doubt recall, these are taxed as ordinary income, so it makes sense that they would be considered IRD.
But why do we care? How is IRD treated by the IRS? Thankfully, it's fairly straightforward: it's taxed as ordinary income. The wrinkle here is that it's taxed as ordinary income to the inheritor -- and this is where tax planning comes into play.
Let's imagine a retired parent Eddard and his adult child Sansa. Eddard has a taxable account, a Roth IRA, and a Traditional IRA. What order does he take his retirement distributions in? While this is a somewhat complex issue, one thing to take into consideration is Eddard and Sansa's relative tax brackets. If Eddard is in a super-low tax bracket, it might make sense to pull from the Traditional IRA first. That way, when his winter inevitably comes, Sansa isn't stuck paying high IRD taxes. Conversely, if Eddard's tax bracket is much higher than his daughter, he might pull from his other assets first and let Sansa pay the IRD taxes at her lower rate.
Cost basis step-up -- or down!
Of course, if Eddard has a taxable account, that throws another wrinkle into the estate planning equation: the "cost-basis step". (See here for a quick review/primer on what cost basis is and why you care.) When he dies, the cost basis of his assets will generally be "stepped" to their fair market value at the date of his death. Oftentimes this means a significant tax savings -- if she moves quickly, Sansa can then sell her highly-appreciated inheritance of Winterfell, Inc. stock (ticker symbol: DIRE) with no capital gains tax!
But what if Eddard is married? Then things can go one of two ways.
If they're in a common law state (like most of the non-Spanish-settled states, excluding Wisconsin), then half of any jointly-owned assets get the step-up. So if they own $200,000 in DIRE stock and the cost basis is $100,000, if Eddard then passes away, Catelyn's new cost basis is $150,000: $50,000 from Catelyn's share + $100,000 from Eddard's stepped-up share.
If they're in a community property state (e.g. Texas), though, they're deemed to own the whole thing together -- which means that the whole thing gets the basis step-up. So Catelyn could immediately sell all their DIRE stock to buy property out in the Eyrie, without worrying about capital gains tax. Pretty sweet, huh?
Of course, the axe swings both ways: if DIRE had a bad run of things before Eddard's death, the cost basis could receive a half-or-full step down. That means a potential capital gains loss -- and hence, an income tax deduction -- that vaporized.
Again, you can see that there are some interesting opportunities for tax planning here. For example, if they were in a common-law state, Catelyn might consider gifting all of her highly-appreciated stock to Eddard to keep in a separate account, so that it gets the full step-up. (Note: they'd have to watch out for the "boomerang rule", which says that assets gifted less than one year prior to death don't get the step.)
Conversely, if they were in a community property state and DIRE had fallen below its cost basis, they might consider selling it sooner rather than later, before a potential step-down in basis due to Eddard's untimely death.
Eddard's not wrong
I know I'm belaboring the Game of Thrones references, but if I may get serious for a moment: winter is indeed coming. And by winter, I mean death. I've said before that estate planning is a red-headed stepchild, and honestly, I don't blame people for not wanting to think about their and their loved ones' mortality. But please: think about these things. Do the work. And yes, hire a fee-only financial planner to help and to hold you accountable for following through, if you need to.
Just get it done!
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.