When it comes to estates and taxes, there are three types of taxes and three kinds of assets, creating different tax implications. Is it any wonder everybody gets so confused?

        To add to the chaos, when you read an article or hear someone talking about taxes, they often don't specify which tax they're talking about! As you'll see, it's not all that hard to understand.  To begin with, the three taxes are:

• the estate tax
• the income tax
• the capital gains tax

• ordinary assets, such as stocks, bonds, mutual   funds, real estate, jewelry, furniture and artwork
• retirement plans, IRA accounts, and annuities
• bank accounts, such as savings, checking, CDs, and the like.

        These investments had profits, not income.  And the profits - called capital gains - are subject to the capital gains tax. This tax is 20% of the increased value of the investments.  But it's paid only when Jack sells; he does not pay this tax until then.  Thus, even though Jack had a total capital gain of $310,000, he paid no tax because he did not sell the investments.  And thanks to a provision in the tax code, his heirs will not pay the capital gains tax, either.  This rule is called the "step-up in basis."

        Jack's "basis" (or cost) of the investments was $100,000; if he sold them during his life-time, the profit would be subject to capital gains taxes.  But by passing the assets to his heirs, the "basis" is the value as of the date Jack died - in this case, $410,000.  Thus, if Jack's heirs sell the assets for $410,000, they pay no capital gains tax - even though Jack bought them for just $100,000!

        So far, so good.  No income tax.  No capital gains tax.  But what about the estate tax?

        The estate tax applies to all your assets, regardless of the type.  You can pass up to $1,500,000 (for 2003) to heirs with no estate tax.  So, in Jack's case, everything passes free of the estate tax, because the total value is under $1,000,000.

        If Jack owned bank accounts, such as checking, savings, money markets, or CDs, the income earned in those accounts would be subject to the income tax.  And the value of the accounts would count toward the $1,500,000 estate tax exemption.

        Next are retirement accounts, IRAs and annuities.  This is where things get confusing.  None of these accounts are subject to the capital gains tax, but they are subject to the income tax and the estate tax.  If you don't pay the income tax while you're alive, your estate or your heir will pay if after you've died.  And these assets will also be subject to the estate tax.

      If you are the beneficiary of someone's retirement plan, such as a 401K or an IRA, you may or may not face a tax liability. It depends on your relationship to that person and whether he or she had begun to receive mandatory minimum distributions (after age 70 1/2) from the account in accordance with IRS rules.

        If you are the spouse of the decedent and if the decedent had not yet begun mandatory distributions, you may do one of three things:
 

1. Leave the account in your spouse's name, even though he or she is now deceased.
2. Roll over the money to your own IRA account.
3. Take the money and run.

 

• December 31 of the year following your spouse's death or
• December 31 of the year in which your spouse would have turned 70 1/2 (the distributions in this case would be based on your life expectancy.

        If you don't leave the money in an IRA, you can spend it as you wish, but you'll be liable for income taxes on the entire amount during the same year.
 
MANDATORY IRA DISTRIBUTIONS HAD STARTED

      If your spouse had already begun mandatory distributions, you may continue to receive annual distributions from the account based on the same method as you spouse had been using, or you may roll the money over to your own IRA.

        If you want to continue receiving the same distributions from the account- using the decedent's distribution method- as your spouse had been receiving, you may do so, provided that your spouse had begun MANDATORY (rather than voluntary) minimum distributions. Mandatory minimum distributions are based on life expectancy tables and other data, and if your spouse had begun these distributions, you may continue them for the remainder of your lifetime.

        However, some people withdraw money from their IRAs prior to age 70 1/2, which while allowable, isn't subject to the mandatory minimum distribution rules. Therefore, if your spouse was taking voluntary distributions, you can't base your distributions on the amount he or she had been receiving. Instead you must handle the account as though distributions had not yet begun.

MANDATORY IRA DISTRIBUTIONS HAD NOT STARTED

        If you want to roll over the account to your IRA, you may do this, and if you do, you won't have to pay income taxes until you make withdrawals from your account. You also will not be able to spend the money.

        If you aren't the spouse of the decedent, you're prohibited from rolling over the money to your own IRA. So, income taxes must be paid on the money you receive. How this is done depends on whether the decedent had begun making mandatory minimum distributions.

        If the minimum distributions had not yet started, there are three ways to pay the income tax:
 

1. TAX PAYMENT OPTION 1: PAY THE TAX RIGHT AWAY- If you choose to receive the entire amount right away, you'll receive a check for the proceeds and you'll owe taxes on it this year, payable at your ordinary income tax bracket.

If it's a large amount of money, this distribution could easily push you into the highest tax bracket, forcing you to lose nearly half of the money to federal and state income taxes. To avoid this problem, consider the next two options.
 

2. TAX PAYMENT OPTION #2: PAY THE TAX WITHIN FIVE YEARS-Instead of paying the tax all at once, you can pay it five years later. By delaying the tax for five years, you avoid being pushed into a higher tax bracket this year. Of course, there are two problems with this idea: You'll be pushed into that top bracket in the fifth year, and you won't receive your inheritance until then either.

A better solution might be to take a portion of the money each year over five years. By spreading out the income, you might be able to avoid getting pushed into the top tax bracket. Of course, this will still force you to delay receipt of some of your inheritance, but if you were merely going to reinvest the money anyway, leaving it invested in the decedent's IRA might be just as good.
 

3. TAX PAYMENT OPTION #3- PAY OVER YOUR LIFE EXPECTANCY- You might choose to withdraw the money from the decedent's account over the course of your life expectancy. By doing so, you'll receive only a small portions of the account each year, and this will help you avoid being pushed into a higher tax bracket. The downside is that you won't receive the entire proceeds from the account right away. In fact, you'll never receive a lump-sum, but instead, merely a monthly or annual income stream. These distributions must begin by December 31 of the year following the owner's death.

If you don't need the money now, this might be your best option, because you with it, you can invest as you wish, let the money continue to grow tax-deferred and withdraw it only at the rate required based on your life expectancy.

If the decedent had already begun mandatory distributions, you can liquidate the entire IRA immediately. If you do, you'll owe income taxes on the entire balance.

If you prefer, you can elect to continue receiving annual distributions from the account using the decedent's withdrawal method. This will spread the tax liability over many years as well as your receipt of the money.