Considering Taxes When Allocating Assets Among Beneficiaries

I recently had a client with a desire to distribute their property upon their deaths to their children in equal shares, but they wanted to give their house to one of their children and to give to the other children other assets of equal value.

The client had plenty of assets to accomplish their equal distribution, as long as we included retirement plan assets as part of the trust fund out of which the shares would be created.

Whenever we need to use retirement plan assets to fund a trust, we have to be mindful of two things: one, the “see through” rules, that allow the custodian of an IRA to look through the trust to determine the identity of the individual beneficiary and then use that beneficiaries life expectancy to calculate the Required Minimum Distribution under the IRA; and two, to allocate the retirement plan assets proportionately among the beneficiaries, or if that is not possible, then to “tax effect” the allocation of the assets.

What do I mean by “tax effect” the distribution of the assets? I mean that we take into account the amount the beneficiaries would receive after calculating the taxes that the beneficiary would have to pay on the assets received.

For instance, in the above example, one child would receive the house, and the other two children would receive portions of the IRA. The child who received the house could sell that house and not have to pay any income or capital gains taxes, because the house received a step up in basis upon the last parent’s death. One the other hand, the children who received the retirement plan assets would have to pay income tax on the retirement plan assets when they are distributed to them out of the IRA. Thus they are not receiving the same dollar value as the child who received the house.

When we “tax effect” the allocation, the children each receive an amount which is closer to an “equal” allocation of the overall estate.

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