Opinion: You can minimize the tax hit when you die — with a little planning

There can be a lot of taxes upon one’s passing, or very little, depending on the circumstances.

Q.: My brother, my mother and I are trying to figure the best way for her to leave what she has in cash for us without it being taxed too heavily. We are only talking about $200,000 with $40,000 in an IRA annuity and the rest in a trust account at a bank. My mother is 88, brother is 66 and I am 62. We have heard that beneficiaries of a trust account aren’t taxed until a large amount of money is involved (thinking it was $5 million) but we are a little confused on which direction we should be looking at going. Thank you for any assistance you could provide.

— Ron

A.: Ron, The taxes at death vary based on circumstances. With a little planning, there could be very little tax consequence for your family even if you plan to cash out of everything.

If the trust is a typical living trust for just her using her Social Security number, most of the assets will likely get a “step up in basis”. This means when the assets are sold, only gains above the value on the date of her death are taxed. So, unless the value of the assets rises substantially from the date of her death, very little tax will be likely be due from what is in the trust.

You mention she has an annuity in her IRA. If she also has one in her trust, you should know that annuities do not get a step up. The earnings on the annuity will be taxable when taken out. Good tax planning would suggest you have the party in the lowest tax brackets take disbursements from the annuity, if possible. Will you and your brother be in a higher or lower tax bracket when you inherit than your mom is in now?

Your relative tax brackets matter for the IRA, too. To the extent there were no nondeductible contributions to the IRA, those funds will be taxable to her if she takes the money out now or converts to a Roth (can’t convert the RMD amount though). A conversion may make sense if you and your brother are both in higher tax brackets than your mom. She’d pay taxes at her lower rate rather than you paying at your higher rate, and you would have access to a pool of tax-free money in time after you inherit the Roth.

If still in a traditional IRA at the time of her death, the funds are taxable to the beneficiaries when distributed. So worst case, if you both got half and took it all at once, you’d each have $20,000 of taxable income. If the beneficiary designations are correct, you should have options for taking the $20,000 over more than one tax year, thus spreading the taxation. Because there is an annuity in the IRA, you should also check the actual annuity contract to see what restrictions the contract may put on distributions in addition to those in the tax code.

The $5 million is probably a reference to estate taxes rather than income taxes. Income taxes apply based on the nature of the asset and type of account regardless of the total wealth of the deceased. The estate tax is based on wealth level. However, assuming none of her exemption has been used during her lifetime through gifts, she can pass $11.2 million free of estate tax if she dies this year. This $11.2 million amount is indexed for inflation going forward so estate taxes should not be a concern.

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Dan Moisand’s comments are for informational purposes only and aren’t a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.