Transfer on Death Tax Implications

A transfer on death (TOD) bank account is a popular estate planning tool designed to avoid probate court by naming a beneficiary to a brokerage account or retirement account. However, it doesn't avoid taxes. In fact, transfer on death accounts are exposed to federal estate taxes and state inheritance taxes upon the owner's death.

Before setting up a transfer on death account, you should review the tax implications of these accounts to determine if this is the most advantageous way to transfer funds to named beneficiaries.

Income Taxes

During your lifetime, you have full ownership and control of assets in a transfer on death account. You can manage the investments as you see fit, make additions or withdrawals, and even close the account if you wish. Since you receive all interest, dividends, and other income, you're responsible for paying federal taxes and state taxes on any taxable income.

Estate Taxes

The Internal Revenue Service (IRS) imposes an estate tax on the value of all of an estate's assets at the time of death. Every taxpayer has a lifetime estate tax exemption. In 2022, the estate tax exemption is $12.06 million dollars. Estates valued under that threshold do not pay estate tax and no IRS filing is required. A federal estate tax is paid on the value of the taxable estate that exceeds that threshold amount.

A handful of states collect estate taxes. Of the states that impose their own tax, the value of the estate must exceed the tax exemption value before any taxes are owed.

The amount of the tax exemption is changeable, so review current IRS and state tax exemption guidelines.

Since a transfer on death account is not a trust, it is part of the decedent's estate. It does not avoid or minimize estate taxes.

Inheritance Taxes

An inheritance tax is a state-imposed tax that you pay when receiving money or property from a deceased person's estate. Unlike an estate tax, beneficiaries pay the inheritance tax and it is usually due shortly after funds are received by the beneficiary.

Fortunately, these taxes are almost a thing of the past. Only a handful of states still collect an inheritance tax. Those states with a tax have a relatively high exclusion amount before taxes are due.

Depending on your relationship with the deceased, you may qualify for an exemption or reduction in the amount of inheritance tax owed. For example, most state tax laws exempt a surviving spouse who inherits property from their deceased spouse.

Capital Gains Taxes

For tax purposes, transfer on death accounts may offer considerable capital gains benefits.

If you owned appreciated stocks in your brokerage account and sold them before your death, you would owe a tax on any profits (capital gains) earned. Simply put, capital gains are the difference between the sale price of an investment and the original purchase price (the cost basis) of that investment.

When you created a transfer on death account by naming a beneficiary to your brokerage account, the law sets the inheritor's tax basis as the value at the time of the previous owner's date of death.

For example, imagine you purchased 1,000 shares of stock for $10 each. Several years later, the stock is valued at $75 a share. If you sold the stock, you'd owe a capital gains tax on $65 profit per share or $65,000. With a transfer on death account, the family members receive stock valued at $75 a share, a step-up from the original cost basis. If they sell the stock for that price, no capital gains tax is owed because it was sold at its fair market value.

Paying the Estate's Taxes with Account Funds

When you die, your estate administrator will need to file your last tax return. If you owe federal estate taxes or income taxes, these will need to be paid before distributions are made to your beneficiaries. State law may require the beneficiary to contribute toward the payment of the estate tax or inheritance tax bill when the estate does not have other funds available.

A few states allow you to place instructions in your will or living trust that require the transfer on death account beneficiary to use those funds to cover any tax liability.

Is a TOD Account Your Best Estate Planning Strategy?

A transfer on death accounts is an efficient way to avoid probate court when distributing securities, but it may not be the optimal strategy for reducing death tax exposure. Talk to a local estate planning attorney to understand the value of a transfer on death account in an overall estate plan.