Many people fail to realize is that there is a “hidden tax” that may impact their estate. This “hidden tax” is the income tax. It may seem counter-intuitive to refer to the income tax as a hidden tax since we all have to deal with the income tax every year. But when it comes to estate planning, it is the income tax that is often overlooked. As an attorney, my focus in estate planning tends to revolve around the big picture of how the assets will be transferred to the heirs. The income tax tends to be the accountants’ territory. Besides, most assets are not taxed as income when they are inherited anyway. However, there is an exception to this general rule that actually impacts a large percentage of individuals. The exception is any asset that is referred to in the tax code as an I.R.D. asset (Income in Respect of a Decedent).
I.R.D. assets are assets that would be taxed as ordinary income if they were left in the hands of the deceased person who owned them. A common example of these I.R.D. assets is a tax-deferred retirement account such as a traditional IRA, traditional 401(k), 403(b) and others. There are other I.R.D. assets as well, such as tax-deferred annuities and savings bonds. All of these assets have an element of deferred income built into their value. If the original owner were to liquidate the assets, he or she would owe ordinary income tax on the deferred income portion. When these assets are inherited, the deferred income element does not disappear. The heirs will have to pay the income tax that is due on these assets.
Under the current tax law, very few people have to worry about paying estate tax. However, many couples and individuals have a portion of their estate that is comprised of some form of I.R.D. asset. The taxable nature of these assets lends itself to a discussion about self-directing the tax liability built into these assets through legacy giving.
I believe the question we should be asking is, “If your heirs are ultimately going to lose a large percentage of the value of these assets to taxes, is there a better use for these assets that will eliminate the taxes?” The answer for many people will be “yes.” As we discuss the tax benefits of planned giving, we may want to move away from the traditional discussion of estate taxes and toward the topic of income taxes. For the majority of couples and individuals, the income tax is the “hidden tax” that they do not realize will impact their estate.
(Jeremy Pharr J.D, FCEP)