Is a TOD Account Taxable?

Is a TOD Account Taxable?

Transfer on death accounts are accounts that allow you to name a beneficiary in the event of your death. Your TOD beneficiary will become the owner of the account when you die, even if your will says something else. Transfer on death tax implications run from capital gains on stocks to estate taxes in the case of large sums to inheritance taxes if the beneficiary lives in a state that has such a tax.

Tip

The amount that's in a TOD account at the time of your death is not taxable under federal law to the person who receives the account, although it may be taxable to your estate. If your beneficiary or the account are in a state with an inheritance tax, he may have to pay that.

What Is a TOD Account?

A transfer on death account is an investment account with a designated beneficiary that will receive ownership of the account upon the death of the current account owner. For example, 401(k) accounts and IRAs are automatically TOD accounts; when your plan is set up, you choose a beneficiary or beneficiaries. You can also set up your own investment account, including money market accounts or other brokerage accounts, and create a TOD designation. TOD is also available for stocks and bonds. If you have a regular bank account, you can use a similar designation called payable on death. In either case, when you die, the account becomes your beneficiary's property.

Taxation of Investment Accounts

Investment accounts, which include retirement accounts, brokerage accounts and bank accounts, all hold money you deposit or contribute into the account, and the money accrues interest over time. Some investment accounts, such as 401(k) accounts and traditional IRAs, are funded by contributions you make out of your paycheck before you pay taxes. In that case, any time you make a withdrawal, you're taxed on the entire amount as ordinary income. In accounts that you fund from your post-tax money (i.e., the taxes come out of your check before you put any money in the account), the deposits or contributions aren't taxable, but the interest is. For example, if you take home $1,000 every two weeks after taxes and deposit that money into your checking account, your bank will report to the IRS the interest you earn on the account during the year, but the rest is not taxed.

Taxation of Inherited Property

Property that is inherited when someone dies may or may not be taxable to the deceased person's estate, and the heir may or may not have to pay an inheritance tax. The federal estate tax comes into play for estates of a certain size, and only a handful of states have an inheritance tax, which is assessed upon the person receiving the property. The gift and estate tax are essentially two parts of the same machine: the gifts you make during your life will have an impact on whether your estate will owe estate tax after you die. The IRS does not consider inherited property to be taxable income, so your TOD beneficiary will not have to pay federal income tax when she receives ownership of the account. However, she will have to pay taxes on any growth in the account based upon how much was in the account when you died.

Federal Gift Tax

The IRS allows each taxpayer to gift up to a certain amount, called the exclusion amount, during the tax year. For the 2018 and 2019 tax years, the annual exclusion amount is $15,000. If a gift in 2018 to a single entity or person exceeds $15,000, you'll need to report it to the IRS. If you give someone $15,000 or less, you don't need to report it. The gift tax also doesn't apply to gifts between spouses or gifts to charities. If you do make a gift over the exclusion amount, you'll have to file a Form 709 with your tax return, but you won't owe any tax at that time. Your gifts over the exclusion amount are added up over your lifetime, and an estate tax is assessed after you die if your estate exceeds the lifetime exclusion amount.

Federal Estate Tax

The estate tax is a tax assessed against your estate after you die. Your executor will have to file an estate tax return if your gross estate, plus any amounts you gave away during your life in excess of the annual exclusion amounts each year, is in excess of the estate tax lifetime exclusion amount for the year in which you die. For individuals who die in 2018, the lifetime exclusion amount is $11,120,000; for those who die in 2019, it will be $11,400,000. For example, if you gave $20,000 to your brother in 2018 and give $20,000 to your brother in 2019, and you die in 2019, you'll have made $10,000 in taxable gifts ($5,000 in 2018 and $5,000 in 2019). If your total estate is worth $100,000, you'll add the $10,000 lifetime taxable gifts for a total of $110,000. Because that amount is less than the 2019 lifetime exclusion amount of $11,400,000, your estate will not file a tax return.

TOD Accounts and the Estate and Gift Tax

TOD accounts do become part of your estate, even though ownership passes to someone else. They function more like a will than a trust, and so the gift of the account is included in assessing whether your estate will be subject to taxation. If you have a TOD money market account worth $12 million with your sister as the beneficiary and you die in 2018, you'll have exceeded the lifetime exclusion amount of $11,120,000 by $880,000. Your executor will need to file an estate tax return, and your estate will be taxed for the gift. However, your sister will not be taxed on her receipt of the base $12 million at the federal level, because inheritances are not considered income by the IRS (although once she owns the account, she'll be taxed on the interest every year). However, if you or she live in a state with an inheritance tax, she may have to pay that.

State Inheritance Tax

Some states have their own separate estate tax, which is also assessed against the estate of the deceased person. In addition, some states also have an inheritance tax, which is paid by the person who receives the inheritance. Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania are the states that have an inheritance tax. New Jersey and Maryland both have an inheritance tax and a state estate tax. Whether the state's tax applies depends upon the state's law, but usually, you'll owe an inheritance tax on any assets located within the state, or if you live in the state.

Income Tax on TOD Accounts after Transfer

Once you die and your beneficiary becomes the owner of the account, the tax basis for the account is set at the amount that was in the account when you died. Going forward, your beneficiary will be taxed on any interest earned on the account from the date she became the owner. For instance, if your TOD money market account has $12 million in it when you die and it goes to your sister in 2018, she will not have to pay taxes on receipt of the $12 million in 2018. However, if the account earns interest of $240,000 in 2019 after she becomes the owner, she'll be taxed on that interest.

Capital Gains on Inherited Stocks

If you have a TOD designation for stocks you own or for an investment account funded by stocks, capital gains tax may come into play if you die and the stocks go to your beneficiary. Normally, income from stocks is taxed based on how much you paid for the stock (your tax basis) and how long you had it before you sold it. The gain on the stock is the difference between what you paid for it and what you sold it for. If you sell the stock within one year after purchase, the gain is short-term and taxed as ordinary income. If you sell it more than one year after you buy it, the gain is long-term and taxed at the long-term capital gains rate for your marginal tax bracket. So if you buy 10 shares of stock for $10 each in 2015 for a total of $100, and you sell them in 2018 at $50 per share for a total of $500, your gain is $400, which will be taxed at the long-term capital gains rate.

Your beneficiary who receives the stock under a TOD designation has an advantage, however. His basis for the stock is the stock's value at your death. If you bought the stock for $100 in 2015 and die in 2018 when the stock is worth $500, and your beneficiary receives the stock when you die, he can sell it in 2018 for $500 and have zero gain, because his basis is $500, not $100.