Many people are not aware that your IRA and any other employee benefit plan that was tax deferred is taxable in a number of ways at your death. It may be taxed by the federal government as part of the federal estate tax. It may also be taxed by the State of Illinois for the Illinois estate tax. In addition, there are specific rules on when the money in these accounts needs to be pulled out by the recipients, which are complicated depending on the circumstances, the beneficiary and if a trust is involved, whether that trust qualifies as a “look through” trust. In any event, when the beneficiaries take the money out of the plan, it is subject to federal income taxes on it.
As you probably have read in the press, the federal estate tax was modified for a two year period to allow Congress to take a look at various options for the federal estate tax. Some in Congress wanted to eliminate the tax, some wanted to raise the exemption, but there was no consensus at the time. Congress enacted legislation that increased the lifetime exemption to $5.0 million. This means in general that if your estate is more than $5.0 million, your estate will be subject to tax on everything above $5.0 million, at a rate that starts in the 45% bracket.
The State of Illinois changed their estate taxes several years back, as they were receiving less tax revenue from estates of persons who died. The state had been connected to the federal system before. When the federal government raised the exemption, more estates did not have to pay federal taxes, which meant that more estates did not have to pay taxes to the State of Illinois. Consequently, the State of Illinois changed the tax to provide an exemption of $2.0 million. Everything above that amount is taxed at 17%.
How does this work in practice? Let’s do a couple of examples. For the first example, let’s assume that your estate (including life insurance, 401(k), house, mutual funds, stocks, bonds and all other assets) is $6.0 million and included in that is your 401(k) and IRA for about $1.0 million. Everything above the $5.0 million is taxed at 41%, so there is a federal estate tax of $450,000. For Illinois purposes, everything above the $2.0 million exemption is taxed at 17%, so the Illinois estate tax is about $680,000. So far, the tax on that 401(k) and IRA is 62%.
When the funds are taken out of the 401(k) or IRA, the beneficiary will pay the tax at his or her highest marginal rate. For purposes of the example, let’s assume that rate is 35% for federal purposes. Residents of Illinois do not pay Illinois income taxes on pensions and annuities, so there is no additional tax for Illinois residents.
As a result, in this simple example, the total tax rate for federal and state estate taxes and federal income taxes is a whopping 97%!
Of course, if your estate is under the $5.0 million and you are not subject to federal estate taxes, you still may have a 17% Illinois estate tax (assuming that your estate is above $2.0 million and under the $5.0 million), along with the federal income tax at the beneficiary’s highest marginal rate. The total tax rate in that circumstance would still be 52%!
At the start of this article, it stated that most people do not know this, but you do now.