You may think your work is done when your estate plan is completed.  However, a remaining step may be informing the kids about what they face.

If you wish to pass your estate on to your children, it might be a good idea to spend some time educating them about the challenges and responsibilities they face. While there are many non-financial considerations, a recent Kiplinger article focused on four income-tax issues specifically: “5 Financial Challenges Your Kids Will Face With Your Estate” (the fifth matter the article discussed was simply the overarching message that it is usually a good idea for the adult children to be aware of the parents’ estate planning).

The five things discussed in the article:

Income Taxes and IRAs. Chances are your children won’t know that they will be paying ordinary income tax on IRA withdrawals. As well, most children will withdraw all of the funds from an inherited IRA or Qualified Retirement Plan within three years of the parent’s death. Some may spend those funds wisely (paying down a mortgage, depending on interest rates); more frequently children do not. In any event, few children will opt to “stretch” the IRA withdrawals over the child’s life expectancy, taking only the Required Minimum Distributions, and leaving funds in the IRA for as long as possible. The smart and self-disciplined children, unless facing a genuine financial crisis, choose the stretch option. The stretch is not merely “kicking the income-tax can down the road.” It is more real net-present-value after-tax money for the child. My preferred proof of this is algebraic (I’m a former electrical engineer), but your financial advisor can run sample projections to show the truth of this statement with numbers. Make sure the children see these numbers and how much better off they will be with the stretch.

Can the kids do an IRA rollover? A spouse can rollover an inherited IRA into their own IRA or 401(k) but a non-spouse beneficiary cannot. If they do, the entire amount of the IRA becomes taxable income. There are no second chances. Make sure that the IRA custodian who will administer the IRA for your heirs, automatically takes care of the RMDs, so they don’t have to worry about it. If they don’t take the RMDs, they’ll have to pay not only the tax on what was withdrawn and what should have been withdrawn but was not, but also a 50% penalty on the amount that should have been withdrawn and was not! We’ve had cases where the IRA custodian has miscalculated the RMD, so the kids may want to consult a CPA or attorney to check the numbers.

What taxes are due on an inherited annuity? Unlike inherited IRAs and Qualified Retirement Plans, inherited annuities usually have at least some income-tax basis. They also typically come with a variety of limitations. Distributions from the inherited annuity may carry out deferred income first, or it may carry out basis and deferred income pro-rata, depending upon whether the annuity was “annuitized” and paying regular payments. Like IRAs and Qualified Plans, all income is taxed as ordinary income, even if the growth was generated internally via capital appreciation.

What is a “step-up in basis”? This applies to capital assets such as stocks, bonds, mutual funds, and real estate not held within deferred retirement accounts. It does not apply to IRAs, Qualified Retirement Plans, annuities, US Savings Bonds, bank CDs, or other deferred-ordinary-income assets. The value of the asset on the day you die, is the cost basis to your heir.  It is not what you paid for it originally. Let’s say you bought a second home for $300,000 and it appreciates to half a million dollars in value. If your child sells the house for more than $500,000—its value on the day of your death—any capital gains taxes will be calculated on the $500,000—the “stepped-up basis”—and not the $300,000 original cost or basis. Be aware that it is also quite possible to get a “stepped down” basis if the asset declined in value between purchase and date of death.

Who will have the details? Set up a family meeting with your estate planning attorney and your adult children at a time that works for all of you. They’ll be more comfortable in the days and weeks after your passing, if they know who they’ll be working with to settle your estate.

Reference: Kiplinger (April 3, 2018) “5 Financial Challenges Your Kids Will Face With Your Estate.”