Life and Death Planning for Retirement Benefits

Chapter 7: Charitable Giving

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 Stepped-up basis at death for non-IRD assets. Most assets (such as a house, car, business, stocks, bonds, mutual funds, etc.) receive a new basis (for income tax purposes) when they pass from a decedent to an heir, equal to the date-of-death value. Because of this new-basis-at-death rule applicable to most inherited assets, the beneficiary (when he later sells the inherited asset) pays no income tax on any built -in capital gain that accumulated in the asset through the date of death. Compared with that treatment, a retirement plan is a less favorable asset for an individual beneficiary to inherit, because (as “IRD”) it does not get a new basis at death. See § 1014(c) for the new-basis-at-death rule (also called “stepped-up basis,” on the assumption that assets always appreciate). ( § 1014(c) does not apply with respect to property inherited from certain decedents who died in the year 2010.) Neil Example: Neil’s mother dies, leaving Neil her house (worth $500,000) and her IRA (also worth $500,000). There is no estate tax, because the estate is under the federal estate tax exemption; Neil’s mother had not used up any of her exemption through lifetime gifts. The house is transferred to Neil. The receipt of this asset is not an income-taxable event, because an inheritance is not considered income. The IRA is registered in Neil’s name as beneficiary of his mother, but no money is taken out of it immediately; so far there is no tax he must pay on the IRA. Now he sells the house for $500,000 and withdraws $500,000 from the IRA. He pays no income tax on the house sale. His basis in the house is $500,000 (the date-of- death value), just as if he had paid $500,000 to buy the house, so there is no gain on the sale and thus nothing to pay income tax on—even though Neil’s mother originally bought the house for just $100,000. The $400,000 of capital gain that built up in the house during Neil’s mother’s life is never taxed, because of the new-basis-at-death rule. However, Neil does have taxable income as a result of cashing in the IRA. The $500,000 distribution is included in his gross income for the year of the distribution. The IRA, unlike the house, does not get a new basis upon the owner’s death. Suppose Neil’s mother had wanted to leave only half her estate to Neil, and half to her favorite charity. She has a choice of assets. She could leave half of each asset to each beneficiary; she could leave the IRA to Neil and the house to the charity; or she could leave the house to Neil and the IRA to charity. It makes no difference to the charity which asset it receives. Whether the charity receives the IRA, the house, or half of each, the charity will receive $500,000 of value from Neil’s mother’s estate, because it will not have to pay any income tax on either asset. For Neil, however, it makes a substantial difference which asset he receives. If he receives the IRA, he will have to pay income tax of up to 39.6 percent, or $198,000 (plus state income tax, if applicable), on the $500,000 when he withdraws the money from the IRA. While his withdrawals could be deferred over a long period of time, and deferral reduces the impact of the income taxes, he might realistically conclude that the IRA is worth less than $500,000 to him. Thus he is probably better off receiving the house, from which he can immediately realize $500,000 of value, without a haircut for income taxes.