Is Transfer on Death Considered an Inheritance? Understanding TOD Assets and Tax Implications

Ever wondered if those assets transferred through a TOD designation count as inheritance? You’re not alone in this confusion. As someone who’s helped many clients navigate estate planning I can tell you this question comes up constantly.

Transfer on death (TOD) designations offer a convenient way to pass assets to loved ones while avoiding the dreaded probate process. But does the IRS and your state government view these transfers the same way they view traditional inheritances? Let’s dive into this important topic with clear, straightforward answers

What Exactly Is Transfer on Death (TOD)?

First, let’s make sure we all understand what TOD means before we talk about inheritance.

A transfer on death designation is a legal tool that allows you to name specific beneficiaries who’ll receive your assets automatically when you die These assets transfer directly to your named beneficiaries without going through probate court.

TOD designations can apply to several types of assets:

• Bank accounts
• Brokerage accounts
• Securities (stocks and bonds)
• Real estate (in states that allow TOD deeds)
• Vehicles (in some states)

While you’re alive, you maintain complete control over these assets. Your beneficiaries won’t be able to use them until after you die. You can always sell the assets, change the beneficiaries, or take back the TOD designation.

So, Is TOD Considered an Inheritance? The Simple Answer

Yes, assets transferred through TOD designations are considered inheritance for tax purposes.

When assets pass to beneficiaries via TOD, they’re treated as part of the deceased’s estate and may be subject to inheritance or estate taxes depending on applicable state and federal laws.

This might seem like a bummer if you were hoping TOD would help avoid inheritance taxes, but there’s still good news: TOD designations do help reduce overall costs by avoiding probate expenses and speeding up the distribution process.

TOD and Tax Implications: What You Need to Know

Let’s break down the tax situation with TOD accounts:

Federal Estate Taxes

TOD assets are included in your federal taxable estate. The good news is that the federal estate tax exemption is very high, at $13. 61 million as of 2024. All of this means that most estates don’t have to pay any federal estate taxes.

State Estate Taxes

If you live in a state with estate taxes, TOD assets will be included in your taxable estate at the state level too. Currently, only about a dozen states have estate taxes, and the exemption amounts vary widely.

State Inheritance Taxes

A few states impose inheritance taxes on beneficiaries who receive assets. The tax rate often depends on the beneficiary’s relationship to the deceased. TOD assets aren’t exempt from these taxes.

Income Taxes and Basis Step-Up

Here’s a significant benefit: beneficiaries typically receive a “step-up in basis” for TOD assets. This means the asset’s tax basis becomes its fair market value on the date of death, potentially eliminating capital gains taxes on appreciation that occurred during the original owner’s lifetime.

Example: How TOD Works in Practice

Let me share a real-world example to illustrate how TOD works:

Imagine an investor with a $50,000 margin account and $200,000 worth of stocks in their brokerage account. When opening these accounts, they filed a TOD form designating their two grown children as beneficiaries, allocating 50% to each child.

Upon the investor’s death, the son and daughter would each receive half of the account balance and stocks, provided they file the proper paperwork. The transfer happens outside of probate, but the value of these assets would still be counted as part of the deceased’s estate for tax purposes.

Benefits of Using TOD Designations

Despite being considered inheritance for tax purposes, TOD designations offer several advantages:

1. Avoiding Probate: This is the big one! Probate can be time-consuming, expensive, and public. TOD assets bypass this process entirely.

2. Simplifying Estate Planning: TOD offers a straightforward approach to distributing assets, especially helpful for modest estates.

3. Maintaining Control: Unlike joint ownership, TOD lets you keep 100% control of your assets during your lifetime.

4. Reducing Administrative Costs: By avoiding probate, you save on legal fees and court costs.

Limitations and Potential Drawbacks of TOD

While TOD designations are useful, they’re not perfect for every situation:

1. Limited Asset Types: TOD primarily works for specific asset types. It’s not applicable to all property.

2. State Regulations Vary: Not all states allow TOD for all asset types. For example, TOD deeds for real estate are only available in about 30 states.

3. Paying Estate Debts: If all your money goes directly to TOD beneficiaries, there might not be enough left in your estate to pay outstanding debts, potentially forcing liquidation of other assets.

4. Potential for Challenges: Disgruntled heirs or creditors might still contest TOD designations in some cases.

How to Set Up a TOD Designation

Setting up a TOD designation is usually straightforward:

For financial accounts:

1. Contact your financial institution
2. Complete their TOD beneficiary form
3. Specify your beneficiaries and the percentage each should receive
4. Submit the form to the institution

For real estate (in states that allow TOD deeds):

1. Prepare a deed with specific TOD language
2. Sign and notarize the deed
3. Record the deed with your county’s property records office

I recommend working with an estate planning attorney to ensure everything is properly set up, especially for TOD deeds. Even small mistakes can create big headaches later.

Alternatives to TOD for Estate Planning

If TOD doesn’t seem right for your situation, consider these alternatives:

1. Will: A traditional will allows you to specify who receives your assets, but these assets will go through probate.

2. Living Trust: A revocable living trust can hold various assets and transfer them to beneficiaries without probate. It’s more comprehensive but also more complex and expensive to set up than TOD designations.

3. Joint Ownership: Adding someone as a joint owner with rights of survivorship means they’ll automatically inherit your share when you die. However, they’ll have immediate rights to the property while you’re alive.

Common Questions About TOD and Inheritance

Does a TOD avoid inheritance tax?

No, TOD designations don’t avoid inheritance or estate taxes. The assets are still considered part of your estate for tax purposes.

What’s the main disadvantage of TOD?

One significant drawback is that TOD assets may not be available to pay estate debts, potentially forcing the liquidation of other assets you intended to leave to specific heirs.

What’s the difference between a beneficiary and a transfer on death designation?

A TOD designation is essentially adding a beneficiary to an account type that doesn’t typically have one. Retirement accounts naturally have beneficiary options, while you’d use TOD for non-retirement accounts like brokerage accounts.

Final Thoughts: Is TOD Right for Your Estate Plan?

So there you have it – transfer on death designations ARE considered inheritance for tax purposes, but they still offer significant benefits by avoiding probate and simplifying asset transfers.

Whether TOD is right for you depends on:

• The types of assets you own
• Your state’s laws
• Your overall estate planning goals
• The size of your estate
• Your family situation

For a comprehensive estate plan, I typically recommend combining different tools – perhaps using TOD for certain financial accounts while having a will or trust to handle other assets and provide instructions for more complex situations.

The best approach? Talk to an estate planning attorney who can look at your specific circumstances and help you create a plan that minimizes taxes, avoids probate where possible, and ensures your assets go exactly where you want them to go.

Remember, good estate planning isn’t just about avoiding taxes – it’s about making things easier for your loved ones during an already difficult time. TOD designations can be a valuable piece of that puzzle, even if they don’t eliminate inheritance taxes completely.

Have you used TOD designations in your own estate planning? I’d love to hear about your experiences in the comments below!