People are naturally going to have questions about the impact of taxation on inherited assets. For the most part, the news is good unless you have been extremely successful from a financial standpoint.
Life insurance proceeds are not subject to regular income taxes, and assets that are distributed through the terms of a will are not looked upon as taxable income by the IRS or the state.
What is the rationale behind these tax-free windfalls? In reality, they are not tax-free at all because the decedent paid taxes during their life. They are passing on assets they were able to retain after they paid their taxes, so another imposition would be double taxation.
In spite of this simple logic, the common sense is thrown out the window when the numbers get big, and we will cover the matter in the next section.
Distributions of the earnings that are generated by assets in a living trust would be taxable, but distributions of the principal are tax-free.
A traditional individual retirement account is funded before taxes have been paid on the income. As a result, the original account holder must pay taxes on the distributions, and this also applies to the beneficiary of a traditional IRA.
Roth accounts are funded with after-tax contributions, so distributions to an account holder or a beneficiary are not taxed.
Federal Estate Tax
There is a federal estate tax that is levied on large estates even though it is an instance of double taxation. Most people do not have to be concerned about this tax because a very significant amount can be transferred tax-free.
This figure is called the credit or exclusion, and it was raised from $5.49 million to $11.18 million when the Tax Cuts and Jobs Act was enacted in 2017. The exclusion has been indexed for inflation since then, and it stands at $11.7 million during the current calendar year.
You should be aware of the fact that the provision in the Tax Cuts and Jobs Act that established this exclusion, which is a record high, is going to expire at the end of 2025. On January 1, 2026, it will revert back to the $5.49 million that we had before its enactment
Married couples can transfer any amount of property to one another tax-free because there is an unlimited marital deduction for American citizens. There is an estate tax efficiency strategy for people that are married to non-citizens, and we will look at it in a future post.
Since 2011, the estate tax exclusion has been portable. This means that a surviving spouse can use the exclusion that was allotted to their deceased spouse, so they would have two exclusions to combine.
Federal Gift Tax
You cannot simply give gifts to your loved ones to avoid the estate tax because there has been a gift tax in place continuously since 1932. During the 1970s, it was unified with the estate tax.
As a result, if you gave $11.7 million in taxable gifts this year and you die on New Year’s Eve, there would be nothing left to apply to your estate. However, there is an additional estate tax exclusion that sits apart from the unified lifetime gift and estate tax exclusion.
The per person annual exclusion can be used to give as much as $15,000 to an unlimited number of gift recipients each calendar year free of taxation without using any of your large exclusion.
There is a medical exclusion that allows you to pay medical bills and health insurance premiums for others tax-free, and there is also a school tuition exclusion.
State-Level Estate Taxes
At the present time, there are 12 states in the union that have state-level estate taxes, and there is a separate tax in the District of Columbia. There is no California estate tax, but if you own property in a state with an estate tax, it could apply to your estate depending on its value.
It should be noted that the exclusions on the state level or lower than the federal exclusion. The Hawaii estate tax exclusion is $5.49 million, and the Oregon exclusion is just $1 million.
Capital Gains Tax
If you inherit assets that appreciated during the life of the person that left you the bequest, the assets would get a stepped-up basis. This means that the meter would be reset, and you would not be responsible for the gains that accumulated during the life of the decedent.
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Our doors are open if you are ready to work with a Burbank, California estate planning lawyer to develop a plan. You can call us at 818-937-2335 set up an appointment, and you can use our contact form if you would rather send us a message.