Inherited Parent's Pension - Tax Consequence Experience

[dhaffner]

I would like to hear Mustachean member's personal experience with tax consequences of inheriting a parent's pension and a portion of their estate. My husband and I currently live in CA and already owe a painful amount ($8-10k) to FED/State tax annually because we have no children, minimal investments, and we rent so I'm trying to figure out how I can minimize the tax burden on the inheritance. Here's a summary of the situation:

My step-dad passed September 2020 and then my mom passed away in February 2021. I'm her only biological child and at some point during that gap she made me the sole beneficiary on her Pension from Unisys. This is being handled completely separate from her/their estate. Unisys has contacted me and I have two options for pay out, I can continue on the monthly annuity of $153.30 which will run through December, 2035, beginning with May, 2021 and will be taxes at what rate I'm not sure. Or I can take a lump sum pay out of $23,327.95 and either withhold 10% or 20% for Federal Tax. I'm not clear on what the CA State tax would be. I need to decide on this in the next 30 days.

My mom also has an Executor managing her estate in Colorado, they're in the process of liquidating her assets and I've roughly estimated her total estate to be around $180,000-$200,000. I also conservatively estimated estate expenses between $60,000 - $80,000 and then the balance will be split between me and my 3 siblings. I don't think that will wrap up until 2022 but I'm not really sure.

And a third consideration is that I am currently pregnant and I'd like to set up an Educational Trust for our daughter. I was considering just rolling the monthly annuity into that if there was tax benefit to it BUT honestly I have only begun researching how to set up an Educational trust and I'm not sure I'd be able to get that done in the next 30 days. I'm leaning away from a 529 College savings plan because I do not want her to be limited to accredited schools and I'd like her to have the flexibility to go to a trade school or non-traditional university - or maybe even build in a no education/age clause.

Anyway, If you've had a similar experience or can point me toward literature I can educate myself with it'd be much appreciated. Sincere thanks!

[secondcor521]

First, my condolences.

Usually pensions are treated as ordinary income for the pensioner, so my guess would be that it would be ordinary income to you as well.  You'd avoid FICA taxes, but you'd pay both federal and CA state income taxes, either on the lump sum this year or on the monthly payments in the year you receive them.

If you have a tax program that you use, you can simulate the effect on your taxes by adding a fake entry as bank interest and the tax effects should be the same.

As far as whether to take the lump sum or the monthly payments, part of that decision is probably how much you can use the money now versus later.  If you're indifferent about that, it looks to me like the implied rate of interest is about 2.07%, so you can think of it as having a bank account with the $23,xxx in it which will pay you 2.07% between now and 2035.  That's a nice interest rate now, but if you took the money and invested it you could probably beat that rate over that time period.

The other thing to think about in terms of lump sum vs. monthly payments is the taxation, as alluded to above.  If you take the lump sum, it'd all be taxable this year.  That may not be so bad if your income is relatively low this year compared to what it will be over the next 14 years.  Taking the payments spreads out the tax impact over the next 14-ish years.

From a quick Google, Colorado does not have any estate taxes, and if you live in California it looks like you don't have inheritance taxes.  Your Mom's estate would be subject to federal estate taxes, but the exemption amount is currently $11.7M so it's likely there will be no federal estate taxes.  So that money should come to you completely tax free.  You should consult with an estate attorney or a tax professional to be 100% sure, though.

There's no tax benefits per se to rolling the pension into an educational trust.  You'll get whatever benefits from the trust or 529 just from putting whatever money you put in, but there's no special benefit for going from the pension to the trust -- you'll still be taxed on the pension income regardless, and then whatever you do with that after that point is not connected to a trust or 529 in any way.

You may want to double check your understanding of 529 account rules.  I believe they can be used at any school which does federal loans, which definitely includes some foreign universities and - I think - some domestic trade schools.  Please also educate yourself on the income tax rates on trusts, because they are quite high, so you may end up sending a lot of your child's education fund to the IRS if you go the educational trust route.

Hope that helps; good luck.

[cool7hand]

I'd take the lump sum and get all those dollars to work in the market right now.

[terran]

I agree with what secondcor has written and having recently experienced an inheritance would add that there can be a few other tax ramifications despite the large estate tax exemption. First, any interest, dividends or capital gains your mother had before she died or the estate had after she died are taxable. I believe the executor can either choose to pay these out of the estate or pass the income on to the heirs to be filed with their taxes. Any capital gains should be minimal since the cost basis of investments/property are stepped up to the value on the date of death. There are some annuity/insurance products that defer taxes on the earnings until distributed -- we had a somewhat significant amount of income from that this year.

[Sandi_k]

Take the lump sum, and then superfund at 529 account for your child. It's 5 years x $15k = $75k all at once. So boom, you're done.

The rest can be invested for retirement, and give you a better tax situation going forward.

[Catbert]

Just be aware that California does not have a tax deduction for 529 plans.  Growth within the 529 won't be taxed assuming it's eventually used for education, but you would still have to pay Federal/CA income tax on the 23K in the year you receive it.

I would probably cash it out.  $150 month can just disappear into a checking account.  23K could be enough to do something with.