Lowering tax liability on inheritance of IRA, other assets, upon owner's death (New Jersey)

Karin Price Mueller for The Star-Ledger writes:  Question. On my passing, my three children will share equally in my remaining IRA worth approximately $100,000. What is their tax liability? They will also be sharing my CDs, worth about $100,000, and they are the beneficiaries of my $100,000 life insurance. My funeral expenses are pre-paid. Should I make any adjustments to lower their tax burden?
-- Ready to go, my wife is waiting

Answer. The state of New Jersey requires an estate tax return to be filed when the gross estate, plus lifetime gifts, exceeds $675,000. 

On the federal level, an estate tax return must be filed if the gross estate, plus lifetime gifts, exceeds $5.25 million in 2013. That amount is adjusted annually for inflation and is scheduled to increase to $5.34 million on Jan. 1, 2014.

Based on the information you provided, your estate will not be subject to estate tax because it is below the filing thresholds, said Catherine Romania, an estate planning attorney with Witman Stadtmauer in Florham Park. 

Moreover, your children will receive the principal amount of your CDs and the face amount of the life insurance policy without any income tax obligation, she said. 

"To the extent they receive any interest or dividends generated by these assets, they will be responsible to pay the income tax on such interest or dividends," she said. 

The children may be able to reduce their income tax liability on the CD earnings by closing the CD account, but they may have to pay an early withdrawal penalty that could offset any tax advantage, said Shirley Whitenack, an estate planning attorney with Schenck Price, Smith & King in Florham Park.
Your IRA is treated differently.

The three children must withdraw a minimum amount from the IRA beginning no later than Dec. 31 of the year after the death of the IRA owner, Whitenack said. 

"The minimum amount is calculated by dividing the value of the IRA on Dec. 31 of the previous year by the life expectancy of the children who inherited the IRA as set forth in the IRS’s life expectancy tables," she said. "Income tax is imposed on the required minimum distribution from a traditional IRA."

If the beneficiary of your IRA is your estate, or if no beneficiary is named, then the IRA must be distributed by Dec. 31 of the year five years after your date of death, Romania said, and income tax will be incurred upon distribution. 

"If instead you name your three children as beneficiaries of your IRA, your children will be able to retain the IRA as an `inherited' IRA and `stretch' the distribution over a period based on their life expectancy," she said. "In this way, the account can grow tax-free over a greater period of time although the amount distributed each year will be subject to income tax."