Bonus Episode! Ask Me Anything: Inheritance and Taxes

Full episode and show notes at: www.sunnybranchwealth.com/blog/inheritance-taxes-ama

Wondering how to avoid a massive tax bill when you inherit money? 

In this AMA, I answered people's questions about the taxes you may pay when someone dies. 

You'll learn why the 2020 SECURE Act dramatically changed the game for inherited retirement accounts and why waiting until year 9 to start withdrawals could be a financial disaster. 

Plus, I'll tell you the one conversation you need to have with your parents now—before it's too late to make the tax-saving moves that matter. 

This episode has the essential financial knowledge that no one teaches you but everyone needs, especially if you're a Millennial or Gen Z expecting an inheritance someday. 

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Transcript

Introduction: Qualified Financial Planning Advice on Inheritance and Taxes

Hi, I'm Katherine. I am a certified financial planner. I am the founder of Sunnybranch Wealth and I am coming at you today with an AMA on inheritance and taxes. I'm gonna just do some housekeeping at the top while I wait for other people to join. The first thing I wanna note, I am not a qualified tax preparer. I'm not a CPA.

This is all sort of general tax knowledge that I'll be providing in this AMA. I can't provide any specific advice. And I also can't provide any specific tax advice specifically to specific situations. To ask questions, you can use the Q&A button or you can use the chat. If you use the Q&A, everyone can see your questions. If you just send a chat to host and panelist, then I am the only one who can see them. So whatever works for you.

Understanding the Differences Between Federal Estate Tax and State Inheritance Tax

Okay, so the first question that I have over here is about how state inheritance taxes interact with federal estate taxes and how you know which ones would apply to your specific situation. So there are actually like a few different areas to unpack here. The first piece, the question is about state inheritance taxes and federal estate taxes. And those are two different things.

So just to kind of recap something that I talk about a lot, there is a federal estate tax. And right now the federal estate tax applies to estates that are larger than $13.99 million. So call it $14 million for an individual or around $28 million for a married couple. So that's like piece one is that federal estate tax for large estates. The second part of the question is about state inheritance tax.

There aren't actually that many states that have an inheritance tax. There are only six, I have the list over here, so I'm looking over here, Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland. So those six states have an inheritance tax. So if the person that you are inheriting from lives in one of those six states, then you are going to, you may, I'll say, you may have to pay inheritance tax. It depends on how big their estate was, your relationship to the person, a couple of other factors. And state inheritance tax is separate from state estate tax. So there are more states, there's 12 states plus DC that have state estate taxes. So we have actually like three separate taxes here that we're talking about. We're talking about state estate tax. We're talking about federal estate tax, and then we're talking about state inheritance tax. And so those things are all different and they don't interact at all. So it's not like, if you pay state estate tax, then you'll get like a credit on your federal estate tax. These things all just kind of stack on top of each other. And so in terms of like an interaction, there isn't really like an interaction between these different taxes. Just like if you, the person who died lived in a state with a state tax, then the estate will pay a state tax depending on the size of the estate. If they lived in a state with an inheritance tax, then you as an inheritor might be responsible for paying an inheritance tax. But like, that just kind of is what it is based on where they're located. So the best advice I have is that if you're wondering like about a specific person, like, would I, would they be subject to a state tax or would I be subject to inheritance tax? The best thing you can do is just look up the estate and the inheritance tax laws in your state to see what the answer is there for you. I'm gonna take a look at my next questions.

Top Tax Mistakes to Avoid with Inherited Retirement Accounts After the SECURE Act

Oh, okay. The most common mistakes that people make when handling inherited retirement accounts from a tax perspective. This is a great question. And it's one that is really relevant right now because it's something I talk about a lot. The rules for inherited retirement accounts changed in 2020. So prior to 2020, there was a certain set of rules about what you could do tax-wise in terms of stretching money out from inherited retirement accounts. After 2020, the Secure Act passed and that set of requirements has changed. So as it stands currently, when you inherit from a retirement account, if you are not what's called an eligible designated beneficiary, so basically like it's an oversimplification, but if you're not someone's spouse, then most likely you were going to have to fully empty that inherited retirement account within a 10 year period. And remember that inherited retirement accounts are taxable. Like every, what happens inside that retirement account, just like an IRA or Roth IRA isn't taxable, but in a traditional, a pre-tax IRA, 401k, whatever account, when you pull a dollar out, that dollar is taxable income. So if you pull $100,000 out, you've recognized $100,000 of taxable income in the year that you made that distribution. So then getting back to that question, like what are the most common mistakes or the most common issues that you see or that I see, it's that people are not aware of this timeline and they don't take that tax into consideration.

Strategic IRA Distribution Planning: How to Minimize Tax Impact Over 10 Years

Because if you inherit say a $2 million IRA and you don't pay attention to it for the first five years, maybe you sort of like take a little bit out here or there when you need cash, you know, maybe now you're five years into it, you've got five years left to fully empty this account, you're gonna be pulling out a significant amount of money every year to empty that $2 million account and all that money is going to be taxable income. And so in most cases, the best thing that people can do when you inherit a taxable retirement account is to take that money out over that 10 year period. And that doesn't mean necessarily that you take it out in like equal installments, like you take out, you know, a 10th and then a ninth and then eighth or whatever. That can work and if you expect your income picture to be the same over that 10 year period, then that might be the best option for you. But if you don't think that's the case, like a lot of people have fluctuations in their income over a decade period, right? Like it may be at the start of a decade, your earnings are relatively low, but because of career growth, whatever, you expect it to be much higher in 10 years, or it might be the opposite. Maybe you're kind of winding down your career. So your income is really high right now, but if you think, you know, in a few years, your income is actually gonna be significantly lower. So when you think about making those IRA distributions, the most important thing to kind of think about is like what your income picture could look like over the next 10 years, and then to build a plan for those distributions that takes that into account.

And if you can't do that, then the next best option would just be to take out sort of like an equal portion or as equal as you can of that every year to fully empty it. And then sort of the least good option, depending on circumstance, depending on the size of the IRA you inherited, whatever, would be to just like fully empty that account in one year. It might make sense if you inherited a small retirement account, like if you know, $30,000, $50,000, $100,000. And like that amount of money, it might not make sense to like spread it out over that period, depending on what tax bracket you're in, what your income needs are, all these other things. But if you inherit a large IRA, like a million dollar plus IRA, then you definitely wanna do some tax planning so that you make sure you're not stuck with a big tax bill all in any given year.

Sibling Inheritance Tax Coordination: What You Need to Know About Tax Control

All right, looking for my next question. How should I coordinate with siblings to minimize the overall tax impact on an inheritance we are sharing? Okay, this is a great question. And it actually gets to like the root of something that a lot of people really don't understand when they're talking about taxes and inheritance, which is that you as an inheritor have basically no control over the tax implications of an inheritance. Once you have inherited, when you have those assets like in hand in your name, then you do have control. Like you can control how those assets are used, how like the tax implications, like you have a little bit more control over, you know, timing of selling and income realization and all of that, you have options there. But if you are just getting these assets transferred to you, like the person who died, the decisions that they made are setting up the tax implications that you are going to realize. And so it doesn't really matter like in terms of like, coordinating with my siblings and this and that, like whatever the tax implications are gonna be, they have been set and they have been set by the person who drafted their estate documents, who transferred assets to you, whatever. Like whatever estate tax they're paying is what they're paying. Like whatever inheritance tax, again, most people don't have to pay inheritance tax, but like whatever taxes are being paid at the estate level, like that's what's happening, right? And so you can't really like, coordinate amongst yourself after it's already happened. Once you have the assets in your hand, you can talk about it. And if you've inherited assets jointly with your siblings, there might be something there that you can work through if it didn't go to step up some basis, if there are potential tax consequences to selling an inherited asset that you inherited jointly. But for the most part, the taxes that happen when you inherit are what they're gonna be and the only control you have is what happens after that when the assets are only in your name. This ties in really well to another question. If I'm expecting an inheritance, how should I prepare in advance? From a tax perspective, this is a great, great question because of what I just said, right? And I think I'm gonna actually wrap it up on this question.

Proactive Inheritance Tax Planning: Essential Family Conversations Before Death

So how should I prepare? Remember what I just said, like not one minute ago, that when you inherit the tax consequences, like the estate tax, whatever, all of that, all of that is set. Like if you inherit, for example, say you inherit that million dollar IRA, the taxes that you're gonna have to pay, you have to fully draw down that million dollar IRA. Like once you've inherited it, that's happening. The estate taxes that are the person who died, their estate is gonna pay. Once that person dies, those taxes are happening. There's not really a whole lot of planning that can happen after someone dies. So all of that being said, the best thing that you can do to prepare in advance is to talk to your family. Talk to whoever it is, the person you think you're gonna be inheriting from about their estate, about how they're structuring their estate, and if they're thinking about the tax consequences.

If they live in the state with an estate tax, if they live in a state with an estate tax, have they done proactive estate planning around that estate tax? If they have large IRAs, have they thought about a strategy to like maybe reduce those IRAs, put them into Roth IRAs or, you know, put them in a charitable remainder trust. There are all sorts of strategies that can be done to reduce the overall tax impact on your inheritance, but you cannot do any of them for the most part. The person that is in charge of doing that is the person whose assets they are before they die. And so there are a ton of reasons why I say it's so important to talk to your loved ones before they die to like really make sure that you've gone over this stuff, you've talked about it, all of that. And so this is just another reason to add to that list is that your inheritance is going to be taxed the way it's going to be taxed when you inherit. But if you can have these conversations, if you can educate yourself now and then bring that education to your parents, to whoever it is you're going to be inheriting from, then you might have a better shot. Okay. So that is my 15 minute time. I hope that you enjoyed this webinar. If you're watching it back, I hope it was helpful. If you have any other questions, you can always email me, Katherine@SunnybranchwWealth.com. Send me a DM on Instagram. And if you have other ideas for other webinar topics you want to see answered, definitely let me know. Thanks for joining me and I'll talk to you soon.