We are asked a lot of questions about taxes on inheritances, and people are usually pleasantly surprised by the answers. With a couple of exceptions, an inheritance is not considered to be taxable income by the state tax authorities or the IRS.
What are these exceptions? Distributions of the earnings that are generated by assets in a trust are taxable, and if you inherit a traditional individual retirement account, you have to report the income when you take distributions.
The distributions are taxable because traditional accounts are funded with pretax income. On the other hand, Roth IRAs are funded after taxes have been paid, so distributions to the primary account holder or a beneficiary are not subject to further taxation.
State-Level Estate Taxes
Californians pay more than their fair share of taxes, but we are fortunate when it comes to state-level estate taxes. We do not have an estate tax in California, but there are 12 states that have their own estate taxes.
If you own property in one of these 12 states, and its value exceeds the exclusion in that state, the tax will apply to your estate. Many people that live in California have property in Hawaii, and there is an estate tax in the Aloha State.
Our neighbors in Oregon have an estate tax as well, and the exclusion is just $1 million. This is the amount you can transfer tax-free before the estate tax would potentially be applicable on the remainder.
Federal Estate Tax and Gift Tax
Regardless of where you live, no American can escape the federal estate tax, but it is only a factor for high-net-worth individuals. The federal estate tax exclusion is $12.06 million in 2022, and the top rate is 40 percent.
There is also a gift tax that is in place to stop people from giving gifts to avoid the estate tax. This multimillion-dollar exclusion applies to your estate and large gifts that you give tax-free while you are living.
However, the first $16,000 that you give to an unlimited number of people each year can be transferred tax-free without using any of your unified gift and estate tax exclusion. This figure was $15,000 from 2018 through 2021, but there has been a $1000 increase for 2022.
If you are married, you can use the unlimited marital gift and estate tax deduction to transfer any amount of property to your spouse in a tax-free manner. Since the estate tax exclusion is portable, a surviving spouse can use the exclusion that would have been allotted to their deceased spouse.
When you hear the term “inheritance tax,” you may assume that it is another way of referring to an estate tax. This is understandable, but in fact, an inheritance tax is different.
An inheritance tax can be levied on transfers to each individual inheritor, but close relatives are typically exempt. There is no federal inheritance tax or California inheritance tax, but there are inheritance taxes in New Jersey, Pennsylvania, Iowa, Nebraska, Kentucky and Maryland.
A California resident could be impacted by a state-level inheritance tax if they inherit property in a state with this type of tax. With regard to the close relatives that are exempt, these would include a spouse, children, parents, and grandchildren in most cases depending on the laws of the state in question.
We Are Here to Help!
If you are exposed to any type of estate tax, we can work with you to implement a tax efficiency strategy to mitigate the damage. And of course, we will be more than glad to help you develop a custom crafted plan if you do not have to be concerned about estate taxes.
We know that some people are reluctant to discuss personal matters with an attorney they have just met. Our firm is all about the golden rule, and we treat our clients the way that we would like to be treated if we were on the other side of the desk.
If you are ready to schedule a consultation at our Burbank, CA estate planning office, we can be reached by phone at 818-937-2335, and you can use our contact form to send us a message.