There’s a new estate tax! What? You haven’t heard the news? Well, maybe that’s because nobody else is calling it the new estate tax. You see, the new estate tax is called the income tax. Let me explain. Think about when your parents or grandparents passed away.
The tax concern at that time was probably estate tax since as recently as 2001 a person’s estate would pay tax on anything over $675,000. But right now you don’t pay any federal estate tax until you have over $11,580,000 for an individual and for a couple you get to double that to $23,160,000 before you pay a penny of the federal estate tax.
In Illinois, you don’t pay any estate tax until you have over $4,000,000. There is no doubling that amount for couples in Illinois. The Illinois estate tax does have some teeth in it that need to be taken seriously for clients who have that much money.
With those thresholds, however, there are a lot of people who state will never have a concern about the estate tax. So what is the tax that almost everybody is going to have a concern about? Income Tax!
Why is income tax concern of yours now when it wasn’t a concern of yours when you inherited your parent’s estate?
The difference has to do with more than just the estate tax threshold. Think about your parent’s life. What world did they grow up and work in?
They grew up in a post-depression world and worked in a world where employers were guaranteeing retirement income through pension plans.
They worked through a highly income taxed environment wherein the 50s, 60s, and 70s income tax rates would exceed 60 and 70%, spiking at 90% at more for the federal government alone!
They spent a majority of their working life in a time when 401K’s and IRAs didn’t even exist! Contrast that with where you have worked and grew up. You’ve worked in a low tax environment, compared to your parents. I know it doesn’t necessarily feel that way, but just take a look at the year-by-year tax rates.
Your income tax rates have been lower than your parent’s. However, you’ve worked in a situation where pension plans are disappearing and it is your responsibility to fund your own retirement through 401(k)s, IRAs, 403(b)s. If you’re like most of my clients, you hope to leave a portion of those accounts to your loved ones as their inheritance.
Now, when you inherited a house or an investment account from your parents you actually enjoyed what’s called a step-up in basis in order to avoid capital gains taxation. The basis is the floor that the IRS uses to determine how much gain or loss you experience with an asset when you sell it. Normally your basis in an asset is what you paid for it.
A step-up in basis means that your basis for an inherited asset is not what your parents, for example, paid for the asset, but rather the value of that asset on or near the date of your parent’s passing. My favorite hypothetical example of the step-up in basis involves George Steinbrenner and the New York Yankees.
George Steinbrenner bought the New York Yankees in 1973 for $8.7 million. In 2010, when George Steinbrenner died, the Yankees were estimated to be worth over $3 billion.
If George Steinbrenner would sell the New York Yankees in January of 2010, before he died, for $3 billion he would have had to pay capital gains tax on $2,991,300,000, which would be a tax bill of around $445 million.
If his kids sold the New York Yankees within six months of George Steinbrenner’s death, they would have paid $0 capital gains on the sale of the New York Yankees.
They decided not to sell but if they had they would have avoided a tax bill of about $445 million. By the way, I’m no Yankees fan, but I will not let anyone doubt the Steinbrenner family’s love for the Yankees (and the income it produces).
They could have sold a $3bassets and had no tax to pay. I would have cashed out 100 out of 100 times. But that’s the power of the step-up in basis.
So if you sell a house within six months of you inheriting from your parents you won’t pay any tax because the basis is not the price they paid when they bought it in 1970 for $18,000.
Your basis is the value of the home when your parents passed away, let’s say $180,000. There are a lot of assets that enjoy a step-up basis – investment accounts, stocks, real estate, all those things usually enjoy a step-up in basis.
However, there are some that do not enjoy a step-up in basis, the most important one for you most likely being your IRA and annuities. Therefore, when your kids inherit your IRA they’re going to be paying income tax at their highest income tax rate from dollar number one.
There’s no 4,000,000 or 11,000,000 or $23,000,000 exemption. Your kids will be paying tax from dollar one hen they inherit your IRA and that is why I say income taxes the new estate tax.
If your state plan does not take into account income tax for both your lives and the lives of your kids, frankly, I think that’s malpractice. I think your attorney needs to be writing you letters saying, “Hey I know you came in in 1994 after your parents died but things have changed and you need to see me.”
It’s what I’m doing with clients after the SECURE Act passed they need to see me. Truly any person who has an estate plan made in 2019 or earlier needs to see me take a look at what, if anything, needs to be adjusted. If my clients don’t want to make changes based on the new law, that’s fine, I get it.
Nobody wants to go through the expense or the time to reconsider their estate plan but what I do for clients who don’t want to come in and make changes based on the law that went into effect on January 1, 2020, I make them sign a letter that says, “You advised me of these things and I chose to do nothing.”
The reason I do that is very simple – when that client passes away their richest kid is going to come after me. They’re going to sue me because they will be paying a whole lot of income tax on their inherited IRA and their parent could have prevented it.
Now, they presumably had a loving relationship with their parent but they didn’t have a loving relationship with me. Nobody minds suing an attorney, so I’m going to have that letter signed by my clients because I need that for my own file.
Conclusion
So what you need to consider today – in fact, what you need to be doing right now is deciding how much of your IRA you think you will be leaving to your kids.
If you’re like a lot of my clients, you are very frugal, you spend less than you make, you have been doing that for many years and that is why you’ve been able to save up in your IRA.
If that is you, your IRA balance is going to keep accumulating, and then it’s going to go to your kids and they’re going to be paying incredible amounts of income tax on an inheritance that could have been much less taxing with the right kind of estate plan.