A lot of people have concerns about how taxes will impact the inheritances that they will be leaving to their loved ones. Generally speaking, inheritances are not subject to income taxes, but there are estate taxes that can affect high net worth individuals.
State-Level Estate Taxes
There are 12 states that have state-level estate taxes, and there is a Washington, D.C. estate tax. The majority of these states are in the northeastern part of the country, and we are in the clear here in Tennessee because there is no state-level estate tax in our state.
However, this does not necessarily mean that state-level estate taxes do not apply to you and your family. If you own property in a state that has an estate tax, it would apply to your estate, but there are exclusions.
An estate tax exclusion is the amount that can be transferred tax-free before the remainder would be subject to taxation. The lowest state-level estate tax exclusions in the country are $1 million in Massachusetts and Oregon.
In addition to Massachusetts and Oregon, these are the states that have state-level estate taxes:
- New York
- Rhode Island
State-Level Inheritance Taxes
An inheritance tax is a different type of taxation. As we have stated, an estate tax is levied on the portion of an estate that exceeds the exclusion, so there is just one instance of taxation. When there is an inheritance tax in place, it can be levied on transfers to each individual inheritor.
Iowa, Kentucky, Maryland, Nebraska, Pennsylvania, and New Jersey are the only states with state-level inheritance taxes. If you were to inherit property in one of these states, the inheritance tax would apply to you unless you are exempt. Close relatives are typically exempt from inheritance taxes.
Federal Estate Tax
There is also the federal estate tax that can consume a significant portion of your estate with its 40 percent maximum rate. Strangely enough, most people would love to be exposed to this tax.
The federal estate tax exclusion is $12.06 million, so it is not a factor if you are not very wealthy. There is also a federal gift tax, so you cannot give large gifts to avoid the estate tax.
If you are married, you can use the unlimited marital deduction to transfer any amount of property to your spouse free of taxation. A surviving spouse can add their deceased spouse’s exclusion to their own because the estate tax exclusion is portable.
People that are exposed to estate taxes can implement tax efficiency strategies, and this will often include the utilization of irrevocable trusts. Grantor retained annuity trusts, generation-skipping trusts, qualified personal residence trusts, and charitable lead trusts are some of the trusts that are used for this purpose.
We touched upon the fact that in most cases, the inheritors do not have to pay federal and state income taxes on inheritances. However, there are a couple of exceptions.
Distributions of the principal in a trust are not subject to income taxes, but you would be required to report distributions of the trust’s earnings. If you are the beneficiary of a traditional individual retirement account, the distributions would be taxable.
Capital Gains Tax
Inherited appreciated assets get a stepped-up basis. This means that the inheritor would not be required to pay capital gains taxes on the appreciation that accumulated during the life of the decedent.
We Are Here to Help!
Our firm can help if you have estate tax concerns, and if you do not, we can work with you to develop a custom crafted plan that is ideal for you and your family.
You can schedule a consultation at our Memphis, TN estate planning office if you call us at 901-763-2500 or 866-977-6325. If you would rather reach out electronically, send us a message and will get back in touch with you promptly.