What is the Typical Tax on Inheritance?
Typical taxes on inheritance may consist of both estate and inheritance taxes. In most of the world, “inheritance tax” and “estate tax” are interchangeable phrases. In the United States, each has a specific legal meaning.
Understanding the difference between estate & inheritance tax
One of the primary differences between an estate tax and inheritance tax is who actually is responsible for paying the tax. To simplify, estate taxes are paid from the decedent’s estate, while inheritance taxes are paid by the beneficiaries of the estate who stand to inherit.
Your estate is the sum of everything you own: property, real estate, investments, cash, and debts. Most estates have an Executor or Personal Representative. This person is personally responsible for handling administrative tasks for the estate, collecting and organizing assets, paying any debts, including funeral expenses, and preparing the decedent’s final personal income tax return, as well as any estate or inheritance tax returns.
Sixteen states and the District of Columbia also impose an estate tax, but rates vary. In most cases, the states follow federal precedent and allow a spousal exemption for estates.
On the other hand, only six states still impose an inheritance tax; Iowa, Kentucky, Maryland, Nebraska (County), New Jersey and Pennsylvania. Inheritance taxes are levied after the estate’s assets pass to the individual beneficiaries. This means each heir is responsible for paying inheritance tax on their portion of the estate. Inheritance tax is a state matter; there is no such thing as a federal inheritance tax. In those six states, the beneficiaries typically have 9-18 months after the decedent’s death to pay inheritance taxes.
Appraising value and tax basis of inherited property
The fair market value of property is both used to calculate the amount of estate or inheritance tax due, as well as determine the income tax basis of the property received by the beneficiaries.
The appraiser calculates the fair market value of all of the assets, including the value of cash, bank accounts, insurance, investments, real estate, collections, art, jewelry and other valuable items. The total is called the gross estate. Next, liabilities such as mortgages, notes, utility bills, state taxes, probate and attorney fees, and other administrative costs are subtracted from the gross estate to arrive at the adjusted taxable estate.
Since the current estate tax is only imposed on estates greater than $5,490,000 per person, the estate tax has become less and less of a burden for all but the largest estates. Also, in the case of a husband and wife or a same sex couple, there is no estate tax on an any amount of the estate left to the Surviving Spouse. This is called the “Unlimited Marital Deduction”.
Further, recent changes in the law allow any unused amount of the $5,490,000 estate tax exemption of one spouse (the first to die) to be used by the estate of the Surviving Spouse when that spouse dies. This effectively allows a total estate of $10,980,000 to pass to a couple’s beneficiaries free of any federal estate tax.
Estate planning for large estates
Very wealthy individuals tend to hire estate planners to handle their affairs. A skilled planner will work with the family to set up trusts, charitable donations, or non-taxable gifts to reduce part or all of the tax burden. Since these reductions are applied before the state or federal government takes their cut, it effectively lowers the taxable value of the estate.
Lowering inheritance tax through advanced planning
Generally, the federal estate tax commands the most attention from those who wish to lower their estate taxes. Many states impose estate and inheritance taxes, although usually tied to the federal estate tax in some way, while others have different rates and exemptions. It’s essential to keep all of these factors in mind in the estate planning process, particularly when determining whether to liquidate assets during your lifetime or let them pass to your heirs after death. This is where advanced tax planning can really pay off for wealthy individuals and their beneficiaries.
One of the best ways to reduce your estate is through an annual gift giving program. Outright gifts of a present interest (cash, marketable securities, shares of a closely-held business, and other valuables to name a few examples) qualify for the Annual Gift Tax Exclusion, at $14,000 per recipient in 2017. You may give the $14,000 to as many individuals as you wish. A married couple may each give $14,000. Gifts qualifying for the annual exclusion have no reporting requirements and most importantly do not use any of the donor’s combined lifetime gift and estate tax exemption, currently $5,490,000.
In fact, no gift tax is payable until the $5,490,000 lifetime exemption has been exceeded. This makes techniques such as “gift splitting” or spreading out gifts to utilize a series of annual exclusions unnecessary for most estates.
Irrevocable Life Insurance Trust (ILIT)
An Irrevocable Life Insurance Trust (ILIT) is another common estate planning technique that may benefit the Owner of the Policy, the Insured, and the beneficiaries of the estate. This is particularly effective if the Insured has minor children. Properly drafted and funded, the ILIT removes life insurance proceeds from both the Grantor’s and Spouse’s estates, while allowing the proceeds to be available to meet the needs of the estate, insured's beneficiaries, and surviving spouse. The ILIT becomes the owner and beneficiary of the life insurance policy.
The ILIT provides liquidity to pay estate taxes, manage the proceeds of the life insurance, and protect the proceeds from creditor claims. There are strict IRS rules that must be followed when both the ILIT is created, as well as if it is funded to pay life insurance premiums. The beneficiaries must have the ability to withdraw the premium funding before the premiums are paid. This is commonly referred to as "Crummey powers", named after a famous court case, and is one of the more sophisticated estate planning techniques with multiple advantages. The Crummey power qualifies the insurance premiums (when contributed to the ILIT by the insured) for the annual gift tax exclusion. Consequently, there is no gift tax return filing requirement, thereby eliminating another cumbersome administrative task.
Charitable Remainder Trust (CRT)
A CRT essentially converts large assets like investment real estate or stocks into income over a lifetime without paying tax when the assets are sold. CRTs reduce your income and estate tax, allowing you to donate to the charity of your choice. Once the asset is transferred into an irrevocable trust, it is no longer is part of your estate.
When the trust sells the asset at market value, you pay no capital gains tax, and the trust pays you an income. This allows you to collect more income over the course of your lifetime. After you die, the rest of the assets is donated to your chosen charity.
Charitable Lead Trust (CLT)
A CLT is basically the opposite of a CRT. Once the asset is transferred to a trust, CLTs reduce the size of the estate and lower taxes, although the trust pays directly to the charity. This payment can be set to a limited number of years or paid until you die. Once the trust ends, if there are assets left, they will be dispersed to your beneficiaries.
Note: ILITs, CRTs, and CLTs can be complicated tax arrangements for many individuals. Confirm you are using them correctly before you structure your tax plans.
Exploring state estate and inheritance taxes
Most states do not impose estate or inheritance taxes. The remaining states break down as follows.
States with estate taxes
Fourteen states impose estate taxes. In 2017, Washington has the highest maximum tax rate at 20 percent; several other states follow close behind with a 16 percent top rate. Although it is not a state, the District of Columbia also levies an estate tax.
- New Jersey
- New York
- Rhode Island
States with inheritance taxes
Six states levy inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Kentucky has the highest top inheritance tax rate at 16 percent. The other three follow closely with a top rate of 15 percent. All of these states provide spousal exemptions; a few also extend exemptions to lineal heirs or immediate relatives.
Determining inheritance taxes
Not all state inheritance taxes are calculated the same way, but most follow a progressive structure. This means the more you inherit, the more you pay in taxes. For example, the first $25,000 you inherit might be taxes at a 1% marginal rate, while the next $25,000 is taxed at a 2% rate, and so on.
Your relation to the decedent will also determine whether and how much you pay in inheritance taxes. Generally, the closer you are the decedent in the family tree, the less you will pay in taxes.
Inheritance tax is highly dependent on the state the decedent lived in, as well as the amount they are passing along. If you have specific questions about your tax situation, consult with an Expert for a customized response.
Taxing capital gains on inheritance
Even if you are fully exempt from inheritance tax, you may be liable for taxes on inherited stocks and bonds when you sell them. However, your cost basis in them will be different from the cost basis of the person who left them to you.
Suppose your grandfather leaves you his shares in an outdoor company called Expert Fisherman. When he bought them, he only paid $75, but they were worth $100 when you inherited them. You decide to sell when the stock is worth $125 per share.
Your cost basis is equal to the value of the shares at the time you inherited them. To determine your profit, subtract the inherited worth of the shares from their sell value. Your profit per share is $25; you owe capital gains taxes on that amount. By comparison, if your grandfather had sold the same shares, he would have owed taxes on his profit of $50 per share.
Inheriting from foreigners
When you receive a gift or inheritance from a foreigner, federal law requires you to report it. A gift comes from a living person; you receive an inheritance from someone who is deceased. If, for example, your uncle dies and you receive part of his estate, it is an inheritance. However, if your aunt is the beneficiary and gives you a portion of what she inherited, it is a gift. Although foreign inheritances may be exempt from state laws, federal standards still apply.
Most people do not own estates large enough to exceed federal exemption limits. However, receiving an inheritance can affect your tax return. If you need insight on estate planning or minimizing inheritance tax, ask an Expert for customized answers.