An Inheritance Tax Overview Any Generation Can Understand
As tax time typically nears, you may consider consulting a tax preparer so you do not have to try to sort through your financials alone. This can help you owe less and file accurately, especially if you had an unusual situation occur, such as the death of a family member.
What is an Estate Tax or Inheritance Tax?
Okay, here is the weird thing. In some countries, they refer to the same thing. In some countries, they do not refer to the same thing. Both taxes broadly get levied on the estate of a deceased person.
You would like to think you could just say, “Well, let’s just focus on the USA.” Even in the US though, while at the federal level there are both, levied differently to different sets of people, some states also levy an estate tax or inheritance tax or both.
Outside the USA, each country’s tax code varies. Some levy inheritance tax, estate tax, and death duty tax, some use the terms interchangeably. If you moved to the US from another country, you really need to check with an attorney and a certified public accountant. You may need to pay taxes in both jurisdictions.
The Difference Between Estate Tax and Inheritance Tax
In the US, the meaning of each term differs vastly. The representatives of the deceased individual pay estate taxes while the beneficiaries of an estate pay inheritance taxes.
The IRS Calculation for Estate Taxes
The IRS has a very specific way of doing things. Such is the case of estate taxes. This taxes your right of property transfer at death. It requires Form 706 which provides an accounting of all items an individual owns in whole, in part or owns an interest in at the time of their death.
The representative of your estate prepares this accounting of your gross estate. The term gross estate refers to the total fair market value of all property an individual owns at the time of their death. Just as it does in home valuation when buying a house, the fair market value of these items of property refers to its current worth, not what the individual paid at purchase or the acquisition value. You can read more about it in IRS Publication 559.
Property Means More Than Houses
Your gross estate refers to much more than just your real estate property. It also includes annuities, business interests, cash and securities, insurance, trusts, and other assets.
Your estate may qualify for certain deductions and/or reductions to value. Once your tax preparer has applied these deductions, they determine the taxable estate.
Yep, there are deductions.
Applicable deductions may include the mortgage balance, related debts, administration expenses for the estate, attorney payments, and property left to surviving spouses, called the marital deduction, and property left to qualified charities. In some cases, the IRS may allow a reduction in value of operating business interests or farms. The estate must qualify for these deductions.
One more step exists before the tax preparer or CPA determines the taxable estate. At this point, they have computed the net amount of the taxable estate. Now they add the value of lifetime taxable gifts. This includes gifts made in 1977 to present. The resulting number represents the taxable estate. Finally, your CPA applies the available unified credit to the taxable estate. This represents the net value of the property, also known as the inheritance tax basis.
Filing Your Estate Tax Return
Most simple estates do not require the filing of an estate tax return. An individual’s estate does require an estate tax return if it exceeds combined gross assets and taxable gifts of $12,920,000 in 2023.
Your estate must file its taxes within nine months of your passing. If, God forbid, your granddad died today, you would have nine months from today to file the estate taxes. The clock starts on the date of death of the original property owner. The IRS sends the estate a letter confirming the closure of the estate once it accepts the tax forms.
Check with the state in which you live, so you can learn about what it requires. You may have another set of tax forms to file for the state for the estate. You and each beneficiary may or may not owe state taxes on the inheritance. You will need to check.
Since January 1, 2011, a deceased individual’s estate may pass the unused exemption to its surviving spouse. The CPA notes this election on the estate tax return for the decedent.
As you well know if you have been reading Taxry for long, every IRS form comes with its own set of instructions. Please refer to the pithily titled “Instructions for Form 706.”
You’ve got that, right?
Good. Now, here is where it gets complicated.
Your tax preparer or CPA will also need to prepare a separate tax form and return if your life insurance proceeds pay out to your beneficiaries in installments. Really. You need a CPA for this. It is that complex. In order to determine the federal tax liability, the total of the installment payments must be separated from the value of the inherited insurance.
I know. I know. I’m providing you an example of what they will do.
Let’s say your granddad dies. Your grandmom was named as his beneficiary. According to his life insurance policy, she gets to choose between a lump sum payment of $100,000 or 12 monthly payments of $10,000. (It may seem odd that the insurance company would be so nice as to offer an extra $20,000, but what happens is that if the beneficiary chooses the monthly payments, the remainder of the funds earn interest. The insurance company simply disburses the funds including the interest earned.
The inherited insurance amount was $100,000. The beneficiary must pay income tax on the $20,000 of interest since it is interest income.
We are very regularly speaking with our clients about making sure their parents have properly planned," Los Angeles attorney Jonathan Forster told US News and World Report. I know. It gets complicated. What can you do?
Oh, get a cup of coffee or tea. No really. It gets more complex from here and you will probably want something to sip. This is why I said that a CPA makes a good idea. You really do not want to have to calculate these yourself.
The Tax You Pay
If you thought the income tax rate was huge, just wait. If the estate exceeds $11,580,000, you will pay 40 percent on anything over that figure. It went up on January 1, 2013, from 35 percent, when Congress passed the American Taxpayer Relief Act of 2012 (ATRA).
Do Not Freak Out
Okay. If you understand what I wrote up to this point, kudos, you probably listened in math class and took a law class or two. Good job.
If you are still sitting there going, “Okay, Carlie, I got my coffee and I have a snack. This still sounds horrid.” then you need to listen. You probably will never need to do this.
How many of you reading this have a net worth of $12 million? Okay, just shy of that, but really. You would only have to file all of this paperwork if the person who died and left you money had an estate valued at nearly $12 million dollars.
Let’s go back to the granddad example. In that one, your granddad had a $100,000 life insurance policy. Let’s say he and your grandmom also own a $250,000 home. Assuming they both worked and saved, in this example, they have a reasonable retirement savings of a combined $500,000. Your grandparents, like most folks, lived comfortably. They were not exceedingly wealthy.
Most folks in the US make about $70,000 per year, according to Investopedia. About half of Americans have no retirement savings whatsoever, according to Smart Asset. Of the half that do, the median retirement savings is $60,000.
Let’s go back to the granddad example. In that one, your granddad had a $100,000 life insurance policy. Let’s say he and your grandmom also own a $250,000 home. Assuming they both worked and saved, in this example, they have a reasonable retirement savings of a combined $500,000. Your grandparents, like most folks, lived comfortably. They were not exceedingly wealthy.
Most folks in the US make about $70,000 per year, according to Investopedia. About half of Americans have no retirement savings whatsoever, according to Smart Asset. Of the half that do, the median retirement savings is $60,000.
So, now you know.
That is how unlikely it is that you will need to fill out these forms or have your CPA do it.
Let’s face it. If you had to file this, you already have the kind of net worth that means you have an attorney on retainer and a CPA plus a financial planner.
Maybe You Live Comfortably
You landed the great job. You put away good money. You dig living well. You must have watched a lot of “Star Trek” and taken the Vulcan phrase, “Live Long and Prosper” seriously. Can you do the V with your hand like Spock? If so, you do really take the Vulcan way seriously.
So, maybe, by the time that God forbid, it is your time to go, your family might have to deal with this. Know that besides the federal taxes, there may also be state taxes.
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State Taxes
I say “may” because as of 2018, only six states collect inheritance tax - Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. One of those, Maryland, also levies an estate tax; it is one of 14 states that levy an estate tax. The District of Columbia also levies an estate tax.
Fourteen states and the District of Columbia collect a state estate tax as of 2018. The federal government also has an estate tax, but it does not collect an inheritance tax.
Clear on that?
The decedent’s estate must pay any owed estate taxes, before any beneficiaries can receive their inheritance. That reduces the amount each beneficiary can receive.
A decedent’s spouse does not pay inheritance tax in any of the six states. Only New Jersey includes those from a registered civil union or domestic partners in the exemption. In Kentucky, children and parents also gain the exemption to pay inheritance tax.
Only in Maryland will you pay both.
The inheritance tax gets based on an individual property request. The estate tax applies to the actual value of the total estate of the decedent.
It also depends on what kind of inheritance it is. Inheriting an IRA or 401(k) could create taxable income. The beneficiary would typically pay taxes on the distributions from the retirement account.
If you live in Iowa and the net estate value comes to $25,000 or less, you pay no inheritance tax. Maryland does a similar thing by not taxing the beneficiaries of estates with less than $30,000 in value.
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When you die, your estate pays any applicable estate tax. Each individual beneficiary pays the inheritance tax only on what they inherited.
Sometimes, the decadent’s estate will pay. Many people plan this into their wills so that their beneficiaries can avoid paying the tax. Doing this insures that each beneficiary obtains their full inheritance.
Typically, when a life insurance policy pays a named beneficiary, the payment incurs no inheritance tax. It is usually subject to estate tax though.
You really have to check with your attorney and CPA because every state differs and the laws constantly change. In 2013, Ohio repealed its estate tax law. Tennessee did the same in 2016. Indiana repealed its inheritance tax retroactively to 2013. If you die in New Jersey, after January 1, 2018, your estate will not pay estate tax, but beneficiaries will still pay an inheritance tax.
Many states with these taxes continue to consider eliminating them. This includes Nebraska, North Carolina and Oregon. North Carolina did eliminate one of the taxes.
How to Reduce the Taxes
You can reduce the inheritance tax each beneficiary owes by giving some things away as gifts before you die. You will earn a deduction on your federal income taxes. You get $30,000 of gifts you can give on your federal income taxes. Your recipient typically does not have to pay taxes on the gift. If they sell it, they incur capital gains tax, but simply getting money or stock as a gift does not typically get taxed. As gross as it sounds, if you know you are dying, go ahead and give some items away before your death. This does not just apply to cash. It includes bonds, stocks, real estate, vehicles, other assets, etc. If you are sitting there thinking, “Wow, this gets confusing.” – that is why you need the CPA and attorney. Imagine what happens if you plan all of your will and testament, file it with the court and then move to another state. You might have planned it all out while living in Maryland, but moved to Wyoming. Maybe, it happened the other way around. Let’s say you lived in a state that had no estate or inheritance taxes. Your move to another state that does. Well, suddenly your well made plans of how to distribute what you own go down the tubes because you probably do not want your beneficiaries to pay 40 percent of what you leave them in taxes. Ah, but you can fix it. You are not dead yet. You meet with an attorney and you amend your will. It is not as extreme an option as you think. People amend their wills all the time. You can work with your attorney and a CPA to create a tax shelter. You could create a trust. You have time to find a workaround so long as you are still breathing and cognizant.
Setting up a Tax Tracker
If you love work, you could end up earning enough to need to read this article. That becomes especially true if you invest well. If this seems the case, set up a tax tracker so you can keep abreast of state and federal tax laws. You can set up an alert that lets you know when the IRS updates its webpage on the topic or when your state’s tax commission updates its webpage.
In Conclusion
You probably will never have to pay an estate tax and maybe not an inheritance tax, but if you do, you know how to handle it now. Plan now for your death by creating your last will and testament. Consult your attorney and CPA, so you can plan in such a way that your beneficiaries can avoid inheritance taxes and your estate can avoid estate taxes. You can do it.