Written By: Lyndol Anderson | West Texas Senior Solutions
This general information gives basic details on options for settling inherited financial accounts. The ramifications to a beneficiary’s personal estate and income taxes will be discussed. The most common types of inherited accounts are listed in order of highest to lowest potential income tax burden.
1) Tax Qualified Accounts: IRA’s, 401(k)’s, 403(b)’s, etc.
2) Tax Deferred Non-Qualified Annuities
3) Bank Accounts: CD’s, Money Markets, Checking Accounts, etc.
4) Life Insurance
1-a) IRA Accounts: The funds in an IRA account have not had the income tax liability addressed. When a non-spousal beneficiary inherits an IRA account, the full income tax burden becomes their responsibility. The income tax rate on the inherited account is calculated at the same income tax rate as the beneficiary. The IRS has rules in effect which will allow the beneficiary of an IRA account to control when the income tax amount is due but the rules are complex and very specific in regard to income tax planning.
1-b) Qualified Accounts: These accounts, such as 401(k)’s, profit sharing plan’s, etc, have the same income tax issues as an IRA. The plan document may control the distribution of assets, leaving the beneficiary few options. The beneficiary could have restrictions on the timing of the payout of the account as well.
Cashing out an inherited tax qualified account or IRA may have a severe effect on personal income taxes and lower the value of the inheritance significantly!
2) Tax Deferred Non-Qualified Annuities: The term Non-Qualified means the original deposit made to the annuity contract was made with funds which had the income taxes paid. Tax Deferred refers to the fact the interest earned inside the annuity is income tax postponed. Income tax becomes due only when the contract owner removes some or all of the funds from the contract.
The tax deferral for the original owner can continue indefinitely. The beneficiary, however, has up to five years to address this built up income tax responsibility. There are ways to control this income tax obligation so it does not adversely affect personal income taxes.
3) Bank Accounts: Once the estate is probated, the named beneficiaries can receive the assets in these accounts. The income tax to the beneficiaries should be minor. The most common taxable event would be on earnings for any CDs in the current year unless the CD is an IRA. If it is an IRA, see the information for inherited IRA’s (Qualified Accounts).
4) Life Insurance: The payout of a life insurance contract is usually controlled by beneficiary designation. If the payment is to a named person, there should not be any probate necessary for the beneficiary. If the designated beneficiary listed on the policy is the “estate of”, there could be probate on the policy. There is typically not any income tax due on the payout benefit of a Life Insurance policy. However, I suggest calling the insurance company prior to filing a claim to inquire if the benefit amount is income tax free. There are some situations where there could be income tax owed on part of the proceeds of the policy.
I hope this communication gives some idea of the rights and responsibilities of a financial inheritance. The concepts talked about in this letter can be very complicated and if a mistake is made, the monetary cost could be high and there may not be a remedy to the decisions made.
About the Author: Lyndol Anderson is a financial professional based out of Abilene, TX whose expertise includes the safeguarding of assets from the continuing threats of inflation, insufficient investment return, outliving funds, taxes, and probate cost. For any questions, be sure to contact him at Lyndol@LHAnderson.com or (325) 829-1430.