Tax Implications of Transfers on Death

Paying the Estate’s Taxes With Account Funds

After death, your estate administrator must file your final tax returns, including any estate tax return. The personal administrator must distribute assets to your beneficiaries after paying all taxes. Thus, if you owe taxes, your administrator must pay them before beneficiary distributions. These taxes can include:

• Federal estate taxes

• Federal or state income taxes

• Gift taxes

State law may require the beneficiary to contribute toward the payment of the estate tax or inheritance tax bill when the estate does not have other funds available.

A few states allow you to place instructions in your last will and testament or living trust. These instructions require the transfer on death account beneficiary to cover any tax liability. It would be best if you considered tax planning as part of your overall estate plan.

Income Taxes

You have full ownership and control of assets in a transfer-on-death account during your lifetime. You can do any of the following:

• Manage the investments as you see fit

• Make additions or withdrawals

• Close the account if you wish

The account’s owner receives all interest, dividends, and other income. Thus, the owner is responsible for paying federal taxes and state taxes on any taxable income.

Estate Taxes

The Internal Revenue Service (IRS) imposes an estate tax on the value of all an estate’s assets at the time of death. Every taxpayer has a lifetime estate tax exemption. In 2023, the estate tax exemption is $12.92 million dollars. Estates valued under that threshold do not pay estate tax; no IRS filing is required. An estate’s personal representative pays federal estate tax on the value of the taxable estate exceeding the threshold amount.

A handful of states collect estate taxes. Of the states that impose the tax, the value of the estate must exceed the tax exemption value before the estate incurs a tax liability.

The tax exemption amount is changeable, so review current IRS and state tax exemption guidelines.

Since a transfer on death account is not a trust, it is part of the decedent’s estate. It does not avoid or minimize estate taxes.

Inheritance Taxes

An inheritance tax is a state-imposed tax. You pay this when receiving money or property from a deceased person’s estate. Unlike an estate tax, beneficiaries pay the inheritance tax. It is usually due shortly after the beneficiary receives funds.

Fortunately, only a handful of states still collect an inheritance tax. Those states with a tax have a relatively high exclusion amount before taxes are due.

Depending on your relationship with the deceased, you may qualify for an exemption or reduction in the amount of inheritance tax owed. For example, most state tax laws exempt a surviving spouse who inherits property from their deceased spouse.

Capital Gains Taxes

For tax purposes, transfer-on-death accounts may offer considerable capital gains benefits. Selling appreciated stocks from your brokerage account can result in a tax liability. You would owe a tax on any profits (capital gains). Capital gains are the difference between the sale price of an investment and the original purchase price (the cost basis) of that investment.

Your tax rate would be your ordinary income tax rate or your capital gains tax rate, depending on how long you have held the stocks.

When you create a transfer-on-death account for a brokerage account, the assets transfer to the beneficiary at your death. The inheritor’s tax basis is the value at the time of the previous owner’s date of death.

For example, imagine you purchased 1,000 shares of stock for $10 each. Several years later, the stock value increased to $75 a share. If you sold the stock, you’d owe a capital gains tax on $65 profit per share or $65,000. With a transfer on death account, the family members receive stock valued at $75 a share, a step-up from the original cost basis. If they sell the stock for that price, they owe no capital gains tax because it sold at its fair market value.

Strategic Transfers as Part of the Estate Plan

Transferring property through gifting, beneficiary designations, or titling in a particular way can remove assets from an estate. Taking such steps can make probate more efficient.

Lifetime Gifts

Gifting property during your lifetime rather than transferring property in a will could be beneficial for tax purposes. You could reduce your taxable estate by implementing planning strategies to minimize tax consequences. You may use gifting to remove assets from your estate without incurring a tax liability.

As of 2023, the annual exclusion amount for gifts is $17,000 per recipient per year. You may make unlimited $17,000 gifts annually without incurring a taxable gift.

These gifts are tax-free to the grantor and the recipient. Gifts exceeding $17,000 per year are subject to the gift tax. Congress can change this amount. It is likely to increase with inflation in the future.

A married couple can double their gift tax exclusion amount. You and your spouse can each give up to $17,000 per recipient per year. For example, in 2023, you and your spouse could jointly give up to $34,000 per recipient per year tax-free.

Beneficiary Designations

Beneficiary designations and transfer-on-death accounts are an efficient way to avoid probate court when distributing assets. You must contact the financial institution to add a beneficiary to your account. Beneficiary designations are common for assets such as:

• Bank accounts

• Life insurance policies

• Brokerage accounts

• Retirement accounts

Although beneficiary designations may make probate more efficient, as discussed above, there may be tax consequences. You must consider potential tax consequences as you develop your estate plan.

Titling property with a transfer-on-death deed is also a way to remove assets from your estate at your death. With a transfer-on-death deed, you can name a beneficiary who becomes the owner after your death. This is an efficient way to transfer real estate at your death.

Your estate can avoid the probate process with careful planning. Lifetime gifts, beneficiary designations, and transfer-on-death deeds can be part of the strategy.

Can an Estate Planning Attorney Evaluate Your TOD Strategy?

A transfer-on-death accounts is an efficient way for your loved ones to avoid probate court. However, it may not be the optimal strategy for reducing death tax exposure in some cases. Before setting up a transfer on-death account, you should review the tax implications of these accounts to determine if this is the most advantageous way to transfer funds to named beneficiaries.

Talk to a local estate planning attorney. They will help you understand using transfer-on-death accounts as part of your overall estate plan.

If you need help with creating a will and other estate planning documents you can use an estate planning attorney or an online legal services company, such as our trusted partner, LegalZoom.