The estate tax is a direct wealth tax collected from heirs on death. Suppose you have an investment account at Interactive Brokers (IBKR) and have just passed away. Then what will be our overseas assets? Is there a difference between the financial assets we hold in a domestic brokerage house and those in a foreign brokerage house? Will our inheritors pay inheritance and gift tax to the other and domestic sides? What are these tax rates? Let’s start with simple questions.
The estate tax in your home country
Each country’s inheritance laws are different. In Turkey, financial assets acquired by persons with Turkish citizenship in foreign countries are subject to tax when passed on to their legal heirs in case of death. However, according to the law, inheritance and transfer taxes paid for taxable goods in foreign countries can also be deducted from the tax base. Still, there are some limitations. On the other hand, this tax does not apply to the statute of limitations. In other words, after 5 years or more, tax is accrued when a determination is made by the relevant public administration. However, the tax is calculated as of the date of transfer and over the amount on that date. In addition, there are no penalties and interest for late payment.
The estate tax in the US for non-residents
According to US tax legislation, the tax rate payable on the death of a non-resident alien is 40%! Even so, this rate is valid if the deceased person’s assets are over $60,000. Otherwise, there is no inheritance and gift tax. To give a concrete example, I invested $100,000 in a US ETF and died. The penalty for our heirs is 40,000 dollars. So they can’t get this inheritance without paying this money.
So how is the process? My US-based brokerage house, Interactive Brokers, is not obliged to follow the inheritance and gift tax. Therefore, my legal heirs must apply to the brokerage house where I have an account to transfer financial assets. Following the application of my heirs, the brokerage firm seems to be requesting documents on whether the requirements of the US Internal Revenue Service (IRS) legislation are fulfilled. So my heirs have to pay taxes to the IRS if I have US-based financial assets or cash in my account.
Domicile concept
First, I need to talk about the concept of ‘domicile.’ It means to be legally settled in a specific sovereignty/judiciary power. When you look at the dictionary, you see an expression such as a legal residence. In other words, just like people, ETFs have a legal home. When I say US domiciled ETF, I mean the ETF subject to US law. So ‘domicile’ also determines the tax law under which the ETF you buy is subject.
Does it matter whether it is a domestic or international brokerage firm?
I don’t have a clear answer to this question yet. Because brokerage houses in Turkey do not have their own networks to invest in global markets. They receive wholesale services from companies such as Interactive Brokers or Saxo Capital, add their profit margins, and offer services in Turkey. Indeed, domestic brokerage firms have a master account in IBKR. Our accounts as customers are opened as sub-client accounts linked to this main account. In addition, a staff member is defined as a plenipotentiary by the domestic brokerage firm. In case of death, I do not know whether the domestic brokerage firm informs IBKR. Maybe they fulfill the demands of the heirs within the scope of Turkish law without informing them. Nevertheless, I think transferring US-origin assets to their heirs should only be possible after the inheritance and gift tax has been paid to IRA according to US laws.
How can we overcome the estate tax problem?
Ireland domiciled ETFs
Ireland does not tax foreign investors’ capital gains and dividend income. There is no inheritance or gift tax. Besides, Ireland’s tax treaty with the US states that dividend income from US financial assets is only subject to a 15% tax. So, suppose you buy an Irish domiciled ETF via a domestic or international brokerage. In that case, your heirs will not be taxed in Ireland on your death. I prefer this within the framework of my investment strategy in foreign markets. In other words, instead of investing directly in the US markets, I invest indirectly through Ireland as much as possible.
Interactive Brokers is essentially a US-based company though there are branches in several countries as separate companies. However, my heirs will not be charged a 40% tax on my death since I own Irish domiciled ETFs. Unfortunately, the cash I hold in this account is governed by US law upon my death. In other words, if I have more than $60,000 in cash upon my death, the US state will impose a 40% penalty on this amount to my heirs. Besides money, you can add stocks and other financial products directly traded in the US markets. What can I say? I hope this will be my only concern in the future. 🙂
Inheritance and gift tax may be paid
You can invest directly in the US markets instead of circumventing tax legislation. Your heirs can pay the inheritance and gift tax if your assets are over $60,000. But at this point, I will share with you a method used by the rich. As you know, the rich don’t like to pay taxes. 🙂 They make wage captives like you and me pay the tax. We can use the same method. So we can have someone else pay the tax for a small fee. How? By taking out life insurance. For instance, I took out simple life insurance two years ago. A $50,000 policy covering death benefits costs me $238—minus the tax deduction.
Let’s say I have $100,000 in taxable assets in IBKR and $50,000 in insurance. Then I died. In this case, the US state will tax the heirs of 40,000 dollars. However, my heirs can take over the portfolio by taking the $50,000 from the insurance company and paying the estate tax quickly. In fact, if they need, they can go to a corporate law firm with $10,000 and deal with the process with their help. You can take out as many life insurance policies as you want. Therefore, you can only take out enough life insurance to cover the tax to be paid to avoid this risk each year.
Instead of using this strategy, I preferred circumnavigating the tax legislation first. Because life insurance coverage increases with age and portfolio size. Therefore, the insurance cost will increase as I age and more assets.
Joint account?
If we share our IBKR account with our spouse, will we not get rid of inheritance and gift tax? In fact, this tactic is the actual situation in joint bank accounts in Turkey. When one of the spouses with a joint bank account dies in Turkey, it is legally assumed that half of the amount in the account belongs to the deceased spouse. Inheritance and gift tax must be paid on this amount. Of course, if neither the tax office nor the bank knows, the surviving spouse can withdraw all the money and deposit it in another bank account. So, in reality, this is often the case in Turkey.
With similar logic, it may be possible to close all positions and transfer the money to the surviving spouse. However, there is a risk of dealing with the US judiciary if US law requires the estate tax for the half, just like in Turkey. There is one more important point. Suppose you do not open the account as a joint account from the beginning, and your spouse becomes a partner later. In that case, you will gift half of your current account to your spouse (or child). This is called gratuitous transfer. According to Turkish law, your spouse has to pay gift tax.
In conclusion
My preferred solution for minimizing taxes within the scope of investing in foreign markets was to invest indirectly in the US markets through Ireland. Of course, in addition to Irish ETFs, I also have the opportunity to invest directly in US stocks or ETFs, provided that they do not exceed $60,000. If I exceed this limit (let’s say I hope), I will take out life insurance against the estate tax risk.
By the way, if you pass away, your heirs have no chance to learn from a central public administration in which banks and brokerage houses you have a presence. In other words, they have to submit petitions to individual banks and brokerage houses with a death certificate. For this reason, it is helpful to prepare your will or at least keep the information in a file in which bank or domestic/foreign brokerage house you have investments. It would even be helpful to prepare a short guide on how to act in such a situation. Also, don’t forget to tell your spouse or trusted friend/relative about the existence and location of this file.
On the other hand, Irish ETFs also have some disadvantages. For example, expense ratios and bid/ask spreads are higher than the US domiciled ETFs. Also, the number of Irish ETF products is more limited than their US counterparts. Therefore, you might consider the direct investment option more attractive. However, suppose you are planning to create an extensive portfolio that you will keep for a very long time for financial independence. In that case, it would be wise to consider tax considerations in personal finance planning.