Heirs may get little, feds lots.
Henry K. Hebeler
9-4-08
If you plan to leave savings bonds and certain other investments for your heirs, you may be making a big mistake. Let’s work through an example:
Suppose you paid $1,000 for either an EE or I Savings Bond. Then you die, or, if married, your surviving spouse dies leaving the bond to your daughter, Pandora, who will shortly discover a box full of taxes. Suppose further that the bond has doubled in value after you owned it for 14 years. When Pandora goes to cash the bond she has to pay federal income tax on the $1,000 gain of the bond. If she is subject to 30% taxes, she gets $2,000 from the bank but nets $1,700 after paying income tax.
But that’s not the only tax. When you died, there was an estate tax that was due. Suppose that your house and other investments put you above the exclusion amount so that the bond was subject to 55% estate tax. (The federal estate tax is scheduled to increase to 55% in 2011 unless changed. Savings bonds are exempt from state estate tax but your other investments may not be.) That means that the amount that Pandora inherited would be less by 55% of the bond’s $2,000 value. So she lost $1,100 of the bond’s value because something else in the estate had to be sold to pay the estate tax. That brings the net she really got from the $2,000 bond to $600 after the $300 income tax and $1,100 estate tax.
If the source of funds to pay the estate tax was also taxable, she got even less. If the money to pay the taxes had to come from a loan, then there would be the cost of the interest on the loan. If the money had to come from an IRA or other deferred-tax account, there would be a loss in value equal to more than the ordinary income tax rate times the $1,100 estate tax bill. That’s because to get $1,100 net, the withdrawal would have to be larger than $1,100 to pay the income tax due on the withdrawal. Even that extra amount to pay for the tax to net $1,100 would be taxable—and all of this is at ordinary income tax rates which may be exacerbated by large deferred tax draws that put you into a higher tax bracket.
Let’s take the simplest case of all to continue the example. Let’s suppose that the entire estate tax could be paid from a money market or savings account in the estate. Then Pandora would net $600 from your inheritance. But 14 years have lapsed since you bought the bond. Suppose inflation has averaged only 3% in the interim. (Inflation has actually averaged over 4% since the Great Depression.) That $600 is worth only $400 in terms of the purchasing power when you bought the bond.
You were very patriotic indeed when you bought a savings bond. Pandora got the equivalent of $400 while the government got the lion’s share of your savings and subsequent gains. If the estate tax payment came from a deferred-tax account, she got a lot less and the government even more.
This example for a savings bond highlights the effects that taxes and inflation can have on investments that you might leave to heirs. While other investments might not have the same tax burden as a savings bond, heirs are going to lose a substantial part of their inheritance to taxes if your estate will be subject to estate tax, particularly if something taxable must be sold to pay the estate tax.
Inflation will also take its toll over the years. The primary beneficiary of inflation is the government because it means it can use cheaper dollars to pay off the national debt and its other unfunded obligations. Also, government income is effectively indexed to inflation and sometimes even amplified by more than inflation as with the alternative minimum tax. Inflation is the sneakiest surprise in Pandora’s tax box.
As for me, I plan to cash in all of our savings bonds before I die and put the money to work in things that have fewer tax and inflation losses. The same is true of my deferred-tax accounts. To reduce tax and inflation losses in other investments, I’m using judicious gifting to my heirs before I die. I can always hope that my heirs may use some of that money for our support if we run out of money while we are still alive.
Of course results are highly dependent on your estate value, the income of heirs and future tax rates. If you have a significant estate, you should discuss this subject with a certified financial planner, estate attorney and/or accountant. Your heirs may be able to do a lot better by planning in advance.