Heir Necessities

What Inheritors Need to Know about Taxes

January 16, 2024 • Katherine Fox, CFP®, CAP® • Season 1 • Episode 4

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Join Katherine as she talks with Sheri Karpa, CPA at Opsahl Dawson, about what inheritors need to know about taxes after someone dies.  

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Katherine:

Hello everyone and welcome to episode four of Planning for Inheritance, a Sunnybranch Wealth podcast covering all things inheritance. I'm your host Katherine Fox, founder and advisor at Sunnybranch Wealth. I'm an inheritor and I built Sunnybranch to serve current and future inheritors who need help managing their financial lives and building a plan to create positive impact with their wealth. Before I introduce our guest today, a quick note that the Sunnybranch guides for inheritors are available for free to anyone who's struggling through any part of the inheritance process. You can find that guide available on my website, sunnybranchwealth.com or get a copy via Instagram @sunnybranchwealth or check out the link in the show notes wherever you listen to podcasts. With that housekeeping out of the way, I'm excited to announce our guest on the podcast. Sheri Karpa, a senior manager at the accounting firm, Opsahl Dawson. Sherry has been working in accounting for over 25 years. She has balanced her career of individual business trust and estate accounting with raising her two sons, an inspiration to all of us with young children. Sheri focuses her practice on valuing her client's unique needs and takes great pride in finding tax saving opportunities for each of them. Sheri, welcome. I am so glad you could join us today.

Sheri:

Well, thank you so much for having me. I'm excited to be here.

Katherine:

Our questions today are gonna focus on real life situations that inheritors and future inheritors encounter. First things first. Can you talk us through the tax filings that an executor or inheritor of an estate should be familiar with?

Sheri:

Absolutely. When you lose a loved one, life can quickly become overwhelming, especially when you're the executor of an estate or your loved one passes without leaving a will. I. So the size of the estate and where the loved one owns assets is gonna determine what tax filings are needed. Right now the federal estate tax threshold stands at 12.92 million. So that is obviously pretty high, um, but it is set to be sunsetting by the end of 2025. So we're estimating that threshold is going to be paired back to somewhere between 5 million and 7 million, depending on inflation for 2026. But in the meantime, if your estate is greater than the 12.92 million, you're gonna have a federal attack, federal estate tax filing requirement, and the executor will need to file a Form 7 0 6 for the estate. Uh, the federal estate tax rates, or somewhere between, you're gonna pay between 18% and 40% depending on the size of the estate. But again, that's for any assets above the 12.92 million threshold. So even if the estate is not greater than that, there are returns that are gonna need to be filed. The decedent's final individual tax return is gonna need to be filed, um, and that will include all of their income up to the date of debt. After the date of death, any income to the estate will need to be reported on a form 10 41, and most of the time that income is going to pass through to the beneficiaries on a Form K one, and they'll need to include that on their 10 40 themselves. Excuse me. So often there's, there's a timeframe in between the person's passing and the distribution of their assets to the beneficiaries. This is the in-between time where a 10 41, uh, return for estates and trust will come in. If there's more than $600 of income that is distributed to the estate, you're going to have a 10 41 filing requirement. They also might have a state filing requirement depending upon where they live and where they own assets. For Oregon and Washington, the exemption thresholds are far lower, lower than the federal exemption. So someone may not have to worry about a federal tax filing, but they may have an organ in Washington, excuse me, filing requirement. Um, California does not have an estate tax, um, but 17 states in the district of Co of Columbia. Either have an estate or an inheritance tax,

Katherine:

So we're talking about potentially income and estate tax returns at both the state and the federal level. You mentioned that Oregon and Washington have. Lower exemption thresholds. Can you talk us through the differences between the estate tax picture in Oregon and Washington?

Sheri:

Absolutely. So Washington's estate tax exemption is currently at 2.193 million. Well, Oregon's estate tax exemption is only 1 million. So you can see how a great deal more people are going to have a state filing requirement, but not a federal filing requirement. So. For most states as well, including Oregon and Washington, they are going to make you include all of your assets, including property that you may own in another state. So you know, people might be thinking $1 million, well. That's a lot. I'm never gonna hit that requirement. And they may be right, but many people also don't realize how quickly your assets can add up. You know that house that you bought 20 years ago for 30,000, or excuse me,$300,000 say that gets a step up in basis as of the date of your death and it could be worth, you know, $600,000 or more now. So that gets the step up. What is the value of your IRA, your 4 0 1 K, your brokerage accounts, even your jewelry, vehicles, vacation homes. So odds are if you, if you own a home and a second home, whether it's a vacation home or a rental, you may see that 1 million threshold a lot faster than you think. So the other important thing to note is that both Oregon and Washington are going to make you include property that is owned in another state. For example, if you are a Washington resident, but you own a beach house in Oregon, that beach house is not only going to get included on your Washington asset list, but you may end up also with an Oregon filing requirement because you've got a home located there as well.

Katherine:

So say I live in a state that doesn't have any state estate tax filing requirements, but I have a $2 million beach house on the Oregon coast. I'm still gonna have to file a state a estate tax turn, return in Oregon and pay. Oregon State Estate Tax on just that $2 million house. Is that correct?

Sheri:

Correct, correct. Yes. Yes. You all of your other assets that are outside of the state of Oregon. Um, will not be taxed, but the, the assets that you have in Oregon are going to be

Katherine:

And how common do you think it is that people. Know that, especially here in Oregon and Washington where we have a lot of people who have lives really in both states. Same with Oregon and California. California and Washington. Is this something that gets missed a lot?

Sheri:

Yes, people have no idea that they're gonna have to pay in two

Katherine:

I'm sure.

Sheri:

You know, they, they, and with Oregon's, or they works really hard to get that, get their, their estate under the Washington threshold, they don't think about the Oregon threshold if they happen to have assets in Oregon. So sometimes that will

Katherine:

No shortage of surprises over here on the tax planning side. Um, other than that specific issue, can you talk more from your personal experience about what tax issues you commonly see trip up the estate settlement process?

Sheri:

Yeah, most people are just simply unaware of the entire process, and they're completely lost on top of the fact that they're grieving and trying to take care of just the general final. Things that need to be done when someone passes away. So our jobs as the professional are to make the client feel more at ease and to help them solve these problems. You know, communication is gonna be the key. Um, most people don't know that they may need to file a 10 41. They have no clue what a 10 41 is. They just assume that they're gonna be able to file. The decedents last return and just divvy everything out and everybody pays the taxes and it's just not quite that simple in a lot of cases. So, uh, you know, they, they just have no idea where to begin. So, you know, they, they also don't know that when a 10 41 is filed, there's going to be AK one showing income reported out to each beneficiary per the will or the trust documents. So a lot of times that's a surprise to them. Um, and to the beneficiaries, they have no idea that they need to wait for that K one in order to file their tax return. That's a big communication issue there. Um, so you know that that really needs to be communicated with the executors so that they can in turn communicate that to the beneficiaries. That's probably the number one shock I see from people really, is that they are completely unaware of the additional income that they're gonna. On their tax return. Uh, they also are unaware of, you know, some of the things that are not necessarily going to be taxable to them. You know, if they're left, you know, the, the decedent's checking account or their savings account, you know, not the taxable income. So just going through the things that are going to be taxed, things that are not going to be taxed, um, and helping them understand all of those things. And whether or not they can use a certain checking account even to pay some of the bills of the estate, that's really important as well. Um, so the other thing that, that the executor may be mindful of is, is leaving funds in the estate to pay for things like the funeral expenses, attorney and accountant's fees, and the taxes. Um, the decedent's final taxes, they, they may owe some tax, so if they distribute everything before they're certain all of the expenses have been paid, they may find themselves on the hook to pay some of these things out of their pocket or their share of the inheritance themselves as the executor of

Katherine:

Continuing on that same thread of, of tax implications, one of the common things that I see, uh, with the new rules for inherited IRAs are. Uh, questions about how long do I have before I have to distribute this account? If the person who died was already taking their required minimum redistributions RMDs, what does that mean for me as an inheritor? Can you talk about what executors and inheritors from estates that include retirement accounts need to know?

Sheri:

So retirement accounts. Have gone through quite a lot of changes um, in, in the last few years there have been a lot of changes to retirement accounts and to inherited IRAs. So they, they've really been through the ringer here. So with the creation of the Secure Act and Secure Act 2.0. They really created some confusion for people and, and you know, we had to do a lot of, of catching up. So there, there are Prese Secure Act inherited IRAs, and that means any inherited IRA prior to 2020 has different rules. Then if you, I inherit your IRA after 20 20, 20 20 and, and to now. Before 2020, you could still use the stretch. IRA, meaning that when you inherited the IRA, you get to take RMDs every year based on your life expectancy. So often that's dragged out for for many, many years. So, and you don't have, your RMDs aren't that big, um, but you do have to take an RMD every year. Now with the passing of. Uh, they created a whole new batch of beneficiaries with different rules to them. So we have the eligible designated beneficiary, the non-eligible designated beneficiary, and a non-designated beneficiary. And we're not gonna dig too deep into all of that, uh, for, for this podcast, but know that there are definitely, um, different categories now. Eligible designated beneficiaries are people like the surviving spouse, um, a minor child, disabled individuals, chronically ill individuals. This is an interesting one who are not more than 10 years younger than the IRA owner. That's something you definitely wanna pay attention to. Um, and then beneficiaries who inherited IRA before 2020, they're on the old stretch rules. So the. Designated beneficiaries can use the stretch IRA still so they can take their RMDs. You have to take an RMD every year, but you get to stretch it out for your life expectancy. Uh, the non-eligible beneficiaries is pretty much everyone else who didn't fit into that care category. Uh, they are subject to the new 10 year rule. Now, the 10 year rule says that you need to deplete that inherited IRA the end of the 10th year. That's both traditional IRA and Roth IRAs. So it's really important that people understand by the end of the 10th year, they have to be empty, whether it's taxable or not. Um, so the, the IRS is now working on updating rules for RMDs. For inherited IRAs. So that's one of the new things that they're working on that still hasn't been fully implemented yet. Even. So essentially what they're saying is that if the decedent had already reached their required beginning date for RMDs and they were already taking these RMDs, the IRS, once you to still be taking those, they want, they want RMDs to continue. So what they're saying now is that if they already started taking RMDs. They want you, even though you have to get deplete the account within 10 years, they still want you to take an RMD every year as well. Um, but that is based on your life expectancy. So it will be a smaller RMD, but you're still gonna need to do it until you deplete the account by the end of the 10th year. Um, this does not apply to Roth IRAs. It's for traditional IRAs because the IRS wants the tax money. I mean, it's plain and simple there. So, um, but because they have not fully implemented this, they keep kind of kicking the can down the road here. They kicked it down the road last year and they kicked it down the road again this year. So essentially right now what we have is we have this guidance, but it has not been implemented yet. So. The IRS has said they are not going to issue any penalties for anyone who has missed these inherited IRA RMDs from 2020 to 2023. Now, this is just on the new ones. If you have a 2019 and prior, it doesn't apply to that. You're supposed to be taking RMDs from those. This is just for the new Secure Act rules. Um. So if you have not taken those RMDs from your inherited IRA, you're okay. You don't have to technically take them because there's no penalty. And if there's no penalty, why are you gonna take it? I will say that if you're going to take that RMD there, there's, can, you can take the RMD, you can take more than the RMD. We do advise that people do some tax planning to make sure that, you know, you got 10 years and if it's a very large IRA, you might not wanna wait until that 10th year to take everything out. You're gonna pay a lot of tax in that last year. So it's not a bad idea for people to consider taking a little bit each year. But, um, back to the RMD, you do not have to take it yet. They are going to look at implementing that. In 2024. So we just keep up to date with that and we will let everybody know, you know, when they do decide to go ahead and implement that. But in the meantime, it is not required because it has not been put into place yet by the IRS. So you're okay. Um, just remember you do need to deplete that account. So taking small amounts each year can help. Um, so. One of the, one of the biggest things that gets missed in a transition here, um, when someone passes away is an RMD. So, for example, we've got John, he was 78 years old. He has an RMD for 2023 of $25,000, but he passed away before he took the RMD. So what is the executor or beneficiary supposed to do? They need to take that RMD. It has to be taken regardless of inherited IRA rules. That is a rule that must be followed. The decedent's final RMD must be taken by the end of the year, you're gonna have to get that distributed. Um, it'll either need to be paid to the estate or to the beneficiary. Um. It needs to be distributed, uh, from the IRA prior to the end of the year. Now, the IRA, excuse me. The IRS does have some exceptions in place for someone who passes away very late in the year. Often there's way too much going on. You don't have time. You don't even know sometimes that they had an IRA until maybe a couple months later. Um, so the IRS does have, uh, exceptions in place for that.

Katherine:

At what point do you usually see estate executor's, administrators, or inheritors reach out to get a CPA involved? Should that be something you're doing, you know, a month after someone dies? Two months, three months, six months? Uh, what's kind of the window there where if you have a, a, an estate that will need a, a tax return filed, you need to have a CPA in your back pocket helping you figure all this out. So if you have an estate that you know is going to need some filings or you are not 100% sure, but it's close enough that you're like, Ugh, I better check this out sooner rather than later. I know that people have a lot going on. There is so much going on when a loved one passes not, not even to mention the emotional, um, healing that needs to. You really need to have someone in your corner to help you through all of these processes. If they are going to need to file a return, you're most likely going to need an estate attorney and someone to help you with the tax filings. Sometimes they're the same person. Some estate attorneys do the tax filings as well, um, but sooner rather than later because they can help you right away start telling you the things that you need to gather, the things not to do. That's really important is a lot of times people just don't know what to do and they end up making mistakes just because they didn't know. A question I get is about the step up in basis. What , step up in basis is when it may apply and what it means for inheritors. Can you walk us through that?

Sheri:

Yes. The Step Up in basis is an absolutely fantastic tax benefit for most assets. So when someone passes away, most of their assets get a step up in basis for the beneficiary. So a simple explanation is this. Scott is single. He passed away this year and he left his estate to his daughter. Jenny Scott owned a home, an IRA worth about $500,000, a brokerage account valued at about $250,000, let's say. Scott bought his home 15 years ago for about $250,000 in many of his securities in his IRA and his brokerage account are quite long term and his cost basis is really low on these assets. that's not a problem for Jenny because Jenny's going to inherit the home at the fair market value as of the date of Scott's death. So if the house is now worth$500,000, that's her basis. Uh, should she, should she decide to sell the home, that's going to be her basis. Even if she sells the home 15 years from now, that is her basis. So she's not going to pay any tax on that. Uh. In, in Oregon, Washington, or California, if she is keeping the home. As far as her inheritance side of that, um, typically beneficiaries who inherit property and then turn around and sell it within a really short time, they don't have any tax implication at all either, because know, all of those sales, while they're quite possibly nice and profitable to the beneficiary, they end up having a loss on paper. Just due to selling expenses, commissions, you know, if you had to do anything to fix up the home, all those kinds of things. So while they still need to report the sale, the tax implication is gonna be usually nothing for them. So that's the house. Now, the brokerage account. Brokerage account is also gonna get a step up in basis, so all of the securities zoned in that a account are gonna get reassessed and assigned a cost basis as of the date of Scott's. Um, most cases a step up and it's gonna save beneficiary a lot of tax, just it, and it's also considered long term no matter what, because they inherited it. Um, but here's the, the that a lot of people don't realize as well, that they may also have a step down in basis, and you still have to do it. The step up or down is required. So you have to do either the step up or step down. If it's a step down, it's a step down. You have to do it. Um, most of the time it's not, but sometimes it is. So, um, you just have to know that that is mandatory and you have to do it. Uh, the IRA is the only piece here that does not get a step up in basis. Nothing within the IRA, um, is going to it. It's inherited as is. Those distributions are going to be at ordinary income tax rates. So there's no step, step up in basis in the IRA. So, you know, that one, that one's a, a real simple one. Um, the more complex issues come in with married couples. So there are community property state rules that come into play at that point. So you've got nine states who are community property states, and those states are Arizona, California, Idaho. Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. So here's, here's a couple of examples to show the difference, um, between a community property state and a non-community property state. So we've got, say Bob and Mary, they live in Oregon, which a non-community property state. They purchased their home 15 years ago for hundred $50,000. Bob passed away this year. So Mary is gonna get a step up in basis for half of that property. So let's say the property is now worth $500,000 to make it easy. Prior to Bob's death, they each had $125,000 in basis in the home because they bought it for 250,000. Split that in two after Bob's death. Mary's basis is now the original half for 1 25 plus. Half of the new fair market value, which is 250,000. So her total basis is 375,000. So let's use that same information about Bob and Mary, but they live in Washington, which is a community property state Washington. Mary's going to get a 100% step up in basis on that. So. Her new basis in the home is the fair market value as of the date of death, which is 500,000. you can kind of see where that is, is gonna be helpful in a non, in a community property state. They get a nice little bit bigger step up in basis. Um, but another keynote that many people are not aware of is that spouses also have up to two years from the date of death to take a married filing joint. 1 21 exclusion. I'll explain in a second. Should they decide to sell the home after the death of their spouse? So that 1 21 exclusion is when a primary, you sell your primary home and you get that $250,000 per person, owner in married couples. It's a $500,000 exclusion. As long as you've met the requirements, um, of. The 1 21 exclusion, which we're not really digging into on that, but, um, in this case, the IRS is going to allow you to still use your spouse's$250,000 exclusion and your own long as you sell the home within two years of the date of their death. So that's a really good planning opportunity for anyone who is thinking about sizing down.

Katherine:

I just really appreciate the. The thorough description with examples, depending on where you live. So is Sherry. One of the most common misconceptions I hear is about giving. And I hear this all the time is that my parents or grandparents are giving me $17,000 per year, which is the most that they're allowed to give me. Can you explain the way the gift tax exemption works when people are living, and then how it plays into the estate settlement process after they die?

sheri-karpa_2_10-24-2023_130352:

You bet. Yes. One of the misconceptions that you are alluding to there is that you are only allowed the annual maximum, which is person. Is that you can stick to that maximum. If you don't wanna file a gift tax return a Form 7 0 9. Now the gift tax return is an informational filing. In most cases, no, no tax is ever gonna be due with the filing of that return, but if you gift more than the maximum of that $17,000 that we're talking about, you'll be required to file that return. Now, the 7 0 9, what it does is it tracks all of your lifetime gifts. Above the annual exemption amounts. So if your gifting exceeds the federal exemption, you're gonna pay tax. But since the current federal exemption is 12.92 million, most people are never going to, they don't have the state that's even gonna come near that amount and they're certainly not going gift that much, so there's gonna be no tax to pay on that. However, the IRS still. Wants you to file that return because you are telling them that you have used some of that lifetime exemption exemption and they want to keep track of how much you have used. You know, you never know you get to hit the lottery the next day and, you know, win that billion dollar Powerball, you know, so they want you to keep track of that and they want, uh, that to be reported. So So here's, here's kind of an example. If you, you, you and your husband give your son a hundred thousand dollars in cash this year. Your son's single, he has no dependents, so you can gift your son 17,000, and your husband can also gift your son 17,000 for a total of 32,000 before any return is filed. You don't have to do anything with that, but since you gifted a hundred thousand. A return is now required due to the additional 66,000 that was gifted. Now again, just a reminder, this is an informational only tax return for most people. No tax is gonna be due. The other thing is your gift. It's exactly that. It is a gift. So your son, he does not pay tax on that gift. That was a gift. On the other side of that, you don't get a tax deduction. For that gift, either. That's a big thing that I hear quite often is do I get a tax deduction for that? How do we report that? You don't, it's not a tax deduction, it's a gift. So, um, so you can keep doing that. And if you have used, you know, much of your federal exemption by the time you die and your estate exceeds the 12.2. million, uh, your estate is gonna pay a federal estate tax on any amounts over that 12.92 million. And again, you know, not a lot of people are exceeding that these days. Um, but it's also a really good point for estate planning. Um, whether you're concerned about federal or the state, the estate taxes, many people are utilizing trusts. They are gifting to wind down their estates so that they can get them below the thresholds so that their families don't have to worry about estate tax returns at all. Um, estate tax returns are quite complex. They take a long time. Sometimes they take several years to finally get through everything and complete the estate. Um, and they're expensive. So, you know, if you, if you need a professional to assist you, it, it's gonna cost quite. It's going to, it's gonna cost So, um, but you know, here a word to the wise. If you have a filing requirement, get a professional to help you with it. It is worth the money that you're going to pay to them because they know the ins and outs. They know what you can deduct. They know what needs to be added to the return, what can be taken out. They know all of those things, and they're going to help you through this incredibly complex. And overwhelming process.

Katherine:

I really appreciate the clear message to our audience. If you've listened through to the end of this podcast, you know that this is a complex process. You've heard about the ins and the outs. And I just want to reiterate the point that If you are. an inheritor and if you're inheriting from a complex estate, you need to hire professionals to be on your team.

Headset (2- Jabra Elite 75t)-2:

Sherri we are at the limit of our time today. I want to thank you again so much for joining us and sharing these really clear answers that are going to be super helpful for anyone who's either going through this right now, or trying to plan ahead to get in front of a potential estate tax problemwhen someone they love dies.

Katherine:

Anyone interested in getting in touch with Sherry and her team at Opsahl Dawson, you can find her at sheri@opsahlco.com. That's S H E R. I. At O P S a H L C o.com. Thanks again so much Sherry and two the next month for the next episode of planning for inheritance with sunny branch wealth.