Two Tax Horror Stories and How You Can Avoid the Nightmare

Paying taxes is just like going to see a good slasher film these days: terrifying and almost guaranteed to make a dent in your wallet. Tax horror stories run the gamut from something as simple as forgetting to file your tax return to dealing with an IRS audit. Below are two tax horror stories, and suggestions on how you can avoid running away from your taxes screaming.

“I HAD TO PAY TAXES ON MY MOTHER’S $2 MILLION IRA.”

Your mother Adele passed away with a $2 million IRA she had inherited from your father, who passed away 5 years earlier. As her only child, you expected to be able to roll the IRA into an inherited IRA in your name. With an inherited IRA, you’ll be able to take distributions slowly over your life expectancy and continue to enjoy the tax deferred growth.

Then you discover the frightening news: the beneficiary on your mother’s IRA was your father and no contingent beneficiaries were named. Since your father predeceased your mother, the IRA must be paid to your mother’s estate. Presumably, this is OK because you are the sole beneficiary of your mother’s estate. However, an estate is not allowed to defer the distributions under the inherited IRA rules. Thus, you lose the ability to defer the distributions over your life expectancy and the entire $2 million will be taxable within the first five years of your mother’s death.

The way out: To avoid this horror story, you and your family members should review your beneficiary designation forms to ensure they are filled out correctly. It is prudent to review your beneficiary designation forms after a major life event, such as a death, birth, marriage or divorce. You want to make sure that the beneficiary, and the contingent beneficiary, of your IRA receives the funds in the most tax-advantageous way possible.

“TAXES TOOK OVER $1 MILLION OF MY FATHER’S ESTATE.”

John and his wife Sarah have a combined net worth of $10.5 million. $8.25 million of the assets is in John’s name and $2.25 million of the assets is in Sarah’s name. One year, Sarah unexpectedly passes away. Her $2.25 million is put into a trust, commonly referred to as a credit shelter trust, and assets in the trust are excluded from her husband’s estate.

A few years later, John dies too. Under current law, any time someone who is worth more than $5.25 million dies, the estate must pay a 40 percent estate tax on the amount that exceeds $5.25 million. In this case, John’s estate will get an exemption for the first $5.25 million, but will pay 40 percent tax on the remaining $3 million. That is $1.2 million that won’t reach John’s descendants.

The way out: There are a few ways to avoid this nightmare. One way is to ensure that both John and Sarah have $5.25 million of assets titled in each of their names during life. If this were the case, Sarah’s trust would have received $5.25 million and all of it would have avoided John’s estate. John’s remaining assets would be $5.25 million and would be exempt from estate tax through John’s estate exemption.

A second way to avoid this tax nightmare is to take advantage of the new portability laws. Remember, Sarah died with only $2.25 million, all of which would have been estate tax-exempt since it is below the $5.25 million mark. But Sarah didn’t use all of her exemption and the remaining $3.0 million was wasted. The new law allows John to transfer or “port” the unused $3 million of exemption to himself. Now John’s total exemption is $8.25 million ($5.25 million plus $3.0 million), and his estate is worth $8.25 million. Thus, there will be no tax on John’s estate.

Here is the catch: the only way to get the benefit of portability is to file an estate tax return for Sarah’s estate. Although an estate tax return for Sarah is not required, the tax benefits far outweigh the administrative costs of filing. In the case of John and Sarah, filing an estate tax return for Sarah in order to benefit from portability would be a savings of $1.2 million.

Have you experienced a terrifying tax horror story? Share it with us by contacting Chris Davis at chris.davis@aprio.com.