Understanding what taxes may apply to your inheritance
You may have recently been informed that you will receive an inheritance from your loved ones. As the excitement wears off, you may begin to realize that this newfound wealth is subject to estate tax. Inheritance tax planning is complicated and may involve federal estate taxes as well as state taxes.
This article aims to provide a basic understanding of what may or may not be taxable to family members who receive an inheritance and some ways to reduce or avoid a tax bill.
Many families get lost in trying to understand the financial jargon associated with inheritances.
Most people use the terms inheritance tax, death tax, or estate tax when referring to income taxes that may be due after receiving an inheritance.
Estate Tax Amount
First and foremost, there is an estate tax for an estate valued at over $12,920,000. This means that every beneficiary can receive up to $12,920,000 without paying any inheritance tax. Double that for married couples. Assuming no tax planning, some estate tax would be due for any amount over this threshold.
For married couples, there is an unlimited exclusion to the surviving spouse for inheritances. The surviving spouse can retitle assets in their name without tax consequences.
Most families with over $25,000,000 in assets will do estate and tax planning to reduce the amounts subject to estate taxes and minimize the amount their heirs will have to pay in taxes.
Some of the common methods used to reduce taxes will be covered later.
Type of Inheritance
Families can inherit all types of assets, such as land, homes, cash, annuities, property (jewelry, collections, or significant household belongings), brokerage accounts, IRAs, 401(k)s, 457 plans, and 403(b)s. These are the most common types of assets that are transferred from one generation to the next.
The rules are relatively simple when family members inherit assets, such as land, a residence, property, or cash.
These assets are considered non-qualified and generally not subject to income taxes. However, subsequent earnings on the inherited assets are taxable unless they come from a tax-free source.
You would include the interest income from inherited cash and dividends from inherited stocks or mutual funds in your reported income.
Determine the Cost Basis
The first thing one should do is determine the cost basis of the inherited assets. The cost basis is generally accepted to be the asset’s fair market value on the date of death (valuation date). In some cases, with varying state laws, you might be able to choose an alternate valuation date. So, if you sell the asset shortly after the date of death, you will most likely incur little to no taxes.
You will only be taxed on any gain the asset has incurred since the valuation date. If there is a loss, this may be deductible.
A good example of this would be a mutual fund. Its value will change from day to day, and depending on when you sell it, you may see a gain or a loss. It may be weeks or months before you are able to sell the asset. Therefore, you must ensure you get an accurate value on the established valuation date as the cost basis.
If a non-spouse inherits a traditional IRA, 401(k), 403(b), or 457 plan (referred to as a qualified account), there will be income tax to pay. Regular income tax must be paid on distributions from these retirement accounts.
The IRS requires a non-spouse beneficiary to withdraw all funds from these accounts within ten years of the date of death of the retirement account owner.
An annual RMD (Required Minimum Distribution) must also be taken for ten years. At the end of 10 years, the account balance must be distributed by the inheriting owner of the account.
Suppose the deceased owner (decedent) had already started taking RMDs. In that case, the RMDs for the non-spouse beneficiary will be determined by a formula. The calculation is based on the longer of either the decedent’s life expectancy or the non-spouse beneficiary’s life expectancy.
If the decedent had not started taking RMDs, then the non-spouse beneficiary will use their own life expectancy to determine the amount of RMD each year.
Inherited Roth IRAs are tax-free to the beneficiary. This is also considered a qualified account. However, they are still subject to RMDs and must be withdrawn entirely within ten years. The distributions are 100% tax-free, and the amount of RMD each year is based on the beneficiary’s life expectancy.
A spouse inheriting one of these accounts can transfer funds to their name. In this case, normal distribution rules would apply. Depending upon their year of birth, the spouse must start RMDs between the ages of 73 and 75. With proper tax planning, an estate can significantly reduce the tax bill to family members.
States with Estate and Inheritance Taxes
The states that require an inheritance tax include Nebraska, Iowa, Kentucky, Pennsylvania, New Jersey, and Maryland. Maryland is the only state to have both estate and inheritance taxes.
This requires beneficiaries to pay taxes on assets when ownership transfers to the benefactor, regardless of the amount.
Legal spouses are exempt from inheritance taxes, meaning that if your husband or wife passes away, you do not have to pay inheritance taxes on any inherited property. In New Jersey, Kentucky, and Iowa, children and grandchildren who receive an inheritance are not taxed. However, all other relatives will be taxed by those states.
States with Estate Taxes
Some states also have their own estate taxes. The estate pays these taxes, not the person who receives the money. Those states are Oregon, Minnesota, Illinois, Tennessee, New York, Massachusetts, Rhode Island, New Jersey, Delaware, Maryland, and the District of Columbia.
You must check with your state’s Department of Revenue, Treasury, or Taxation for details or contact a tax professional to determine if you will be subject to estate or income taxes.
Minimize Costs with Inheritance Tax Planning
Some common ways to minimize an estate’s overall tax situation are to conduct a thorough review of the estate plan and tax planning. This will help to ensure your estate plan evolves as tax laws change. The federal estate tax can be as high as 40%.
For example, if an individual’s estate were valued at $15 million, and, with proper estate planning, they took advantage of the $12,490,000 exemption, they would only be required to pay estate taxes on $2,510,000. That could reduce their tax from $4,996,000 (40% of $12,490,000) to $1,004,000 (40% of $2,510,000). The exemption amount continues to change, so always check with a qualified advisor when planning for inheritance.
The most common way to reduce the size of your estate is by setting up a trust, specifically an irrevocable trust. An irrevocable trust can take full advantage of the $12,490,000 exemption per person.
This will essentially remove that portion of the assets from the estate, so they are not counted in the tax assessment. For married couples, this amounts to almost $25 million that can be exempted and not subjected to estate taxes. This does not necessarily preclude the beneficiaries from paying taxes once they receive the assets.
Life insurance is another common method to help pay estate taxes after someone has reached the exemption thresholds.
The use of life insurance to pay taxes must be set up correctly. Let’s use my example above, where the tax liability is $1,004,000. If an individual purchases a million-dollar life insurance policy and maintains individual ownership, he or she has only compounded the tax liability.
The death benefit from the life insurance would be added to the estate, causing the estate to have a $3,510,000 tax liability ($2,510,000 + $1,004,000).
ILIT – Irrevocable Life Insurance Trust
The use of life insurance must be created in conjunction with an Irrevocable Life Insurance Trust (ILIT). Like the trust mentioned above, the policy is no longer part of the estate. Upon the insured’s death, the proceeds can be used to pay the estate taxes that are due. In this case, the ILIT is the owner and beneficiary of the life insurance policy.
Conclusion – Inheritance Tax Planning to Keep More of Your Money
Inheritance tax planning, regardless of the size of the estate, is imperative. The tax bill can be minimized by understanding the rules and regulations of how wealth is transferred from one generation to the next.
No one wants to pay taxes. However, it is almost inevitable when it comes to inheritance. It is essential to have discussions with family members to determine ahead of time what tax liabilities may be incurred upon receipt of an inheritance.
Working with an estate planning lawyer and a Certified Financial Planner (CFP®) will help ensure your loved ones receive an inheritance with minimal tax implications. It is best to have these discussions sooner rather than later to avoid unintended consequences.
Once these plans are completed, they must be reviewed annually to ensure changes in tax laws are addressed. The estate tax exemption level is scheduled to revert to historical levels of about $5 million when the Tax Cuts and Jobs Act sunsets in 2026.
Tax changes can have a dramatic effect on your overall estate plan. Don’t leave things to chance. Start planning now.