This publication explains how to avoid paying taxes on an inheritance. And, yes, planning an inheritance can be emotional.
You would look back, reflecting on your legacy and how far you have come. While you plan the best way to pass on your inheritance to loved ones, proper estate planning is necessary, including being aware of the various tax implications.
What does inheritance tax mean?
Inheritance tax is typically levied by select state governments. It is not imposed at the federal level, so the IRS (Internal Revenue Service) does not come in. When you inherit an estate from a deceased person, inheritance tax comes into play.
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Being subject to the inheritance tax depends on your state, the relationship you shared with the deceased, and the inheritance value.
Apart from inheritance tax, there are other taxes that can be levied at the state and federal levels.
Types of inheritance taxes
Inheritance taxes are infamously nicknamed death taxes, and refer to various taxes that come into play in an inheritance. Inheritance tax is a specific type of tax but merely one of the various taxes that the IRS and state governments assess.
Also, note that the federal level does not impose all taxes on inheritance. Moreover, the various inheritance taxes are not levied in all states.
Below are 3 major types of inheritance taxes you need to know:
You are levied inheritance tax when you receive an inheritance, and there is no federal inheritance tax but there is a federal estate tax. The 6 states that assess inheritance tax include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
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When an amount exceeds the threshold in your state, inheritance taxes are imposed. Thus, you are not subject to tax if you are under the threshold in your state.
Your relationship with the deceased may also exempt you from taxes. In some cases, immediate family members are spared.
Contact the tax board website of your state to find out the exemption amount, exempt persons, and the tax rate.
The tax rate is typically roughly between 5 and 15 percent, depending on how much exemption amount the inheritance exceeds.
Capital gains tax
Both federal and state governments levy capital gains tax which is assessed when you sell the inherited asset.
The government only assesses capital gain tax on the profit you made off of the stepped-up in basis value. Thus, it is more forgiving compared to income taxes.
Suppose you inherit a house originally purchased for $100,000 but was worth $200,000 at the time of the owner’s death.
$200,000 is the stepped-up in basis value. If you sell the house for $250,000, you are only subject to capital gains tax on the $50,000 made off the stepped-up in basis amount. The original purchase price is not considered in the tax.
About 29% is the average state-level capital gains tax rate, except you reside in a state with no income taxes. The federal capital gains tax depends on your income bracket and is on a sliding scale.
Below is an infographic by Tax Foundation indicating the combined federal and state capital gains tax rates for various states:
Whether due or undue, estate taxes depend on estate size. $11.7 million is currently the federal estate tax threshold, and the estate does not owe taxes if its fair market value does not exceed this threshold.
The high number is interpreted as many estates not owing estate taxes at the federal level. But you will face a massive tax rate of 40% if you exceed the $11.7 million threshold.
Our choice of words means that the estate that owes the tax, and not who inherits it. This is so because the government levies estate taxes upon the decedent’s passing. The taxes are paid before distributions take place, and the appointed estate trustee is responsible for paying taxes out of the estate.
States that impose an estate tax include Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington, and Washington DC.
The threshold ranges between $1 million and $7.1 million in the various states, so confirm the threshold and rate in your state.
How to avoid paying taxes on an inheritance
To prevent your hard-earned legacy from getting eaten up by taxes, do the following to avoid inheritance taxes:
Leverage the alternate valuation date
The value of an estate is based on its fair market value at the time of the decedent’s death for tax purposes. However, you can select the alternate valuation date, which is 6 months after the death of the decedent.
This option is available in the case of less valuation of the state, which helps to reduce the gross value and tax liability.
If you sell properties within these 6 months, they are evaluated on the date of the sale rather than the date of the descendant’s death.
Place the assets in a trust
Transfer your estate into a trust if you plan to create an inheritance. “A trust is an estate planning document working in tandem with a last will and testament.”
So, place your assets into the ownership of a trust, which is also not considered an individual. Trust does not require probate to pass on assets to your beneficiary. This protects your privacy and protects you from expensive fees.
Irrevocable trusts also protect your estate from estate and income taxes.
Minimize IRA distributions
You should minimize IRA distributions to avoid paying taxes on inheritance. IRA taxes can be minimized IRA taxes through Roth conversion. See a financial advisor for analysis to determine if minimizing IRA distributions is a viable option.
Retirement accounts are commonly included in an inheritance. But IRA distributions are taxable, unless for Roth IRAs. The distributions can be spread by a spouse throughout their lifetime. Some other beneficiaries have 10 years to distribute the account.
Donations to charities
Donations to charities might seem counterintuitive but sizeable gifts and donations can lower overall tax liability. You would also get a good feeling assisting those in need.
You can make donations amounting to $15,000 without being subject to gift taxes. This means being able to make small gifts to your beneficiaries every year before you pass away, lowering your overall taxable amount.
Commonly inherited assets and taxes they might be subject to
Inherited assets are generally categorized into stocks and cash, retirement accounts, real estate, art and other collectibles, and life insurance policies.
- Stocks and cash. Generally, you do not owe income tax when you inherit cash. However, you may be liable if the cash payments you receive would have been taxable for the decedent. These include bonuses, salary payments, or debt payments made after their death. You are also for capital gains tax from income made off of stocks and securities.
- Retirement accounts. IRAs and 401Ks are examples of retirement accounts that tend to be sensitive to income tax. Retirement accounts distributions are equally taxable as income.
- Real estate. Under certain circumstances, real estate may be subject to capital gains tax and income tax. You will be subject to capital gains tax if you sell an inherited property. You are only taxed on profit made using the property stepped-up in basis value.
- Arts and other collectibles. Arts and collectibles operate similarly. If you rent out an inherited property, you can be liable for income tax. Nonetheless, your taxes can be written off as a business expense.
- Life insurance policies. Life insurance policies are tax-friendly since proceeds from a life insurance policy are subject to tax. A beneficiary does not have to pay any income tax on them. However, if you elect to take installments instead of a lump sum, you may be taxed on any interest earned on the account balance.
You could always be fortunate to avoid paying taxes on inheritance. However, you might owe a lot if you have a large estate.
You need to understand tax implications in inheritance and estate planning. It is also advisable to place your assets in a trust for protection.