The tax situation that applies to inheritances is quite favorable for the vast majority of Americans. If you receive an inheritance through the terms of a will, you are not required to report the income when you file your tax returns. This would also apply to insurance policy proceeds.
Inherited appreciated assets get a step-up in basis. To explain through the use of a simple example, let’s say that your grandfather bought 1000 shares of stock for $10 a share many years ago. When he dies, he leaves you the stock, and it is worth $100 a share.
Your grandfather paid $10,000 for the shares back in the day, and they are worth $100,000 on the day that you inherit them. You would not be responsible for the $90,000 in capital gains, because the assets would receive a step-up basis.
For your capital gains purposes, the basis would be $100,000. If the assets continue to appreciate, you would be required to pay the capital gains tax if you realize a gain.
Federal Transfer Taxes
On the negative side of the equation, high net worth individuals are not so lucky. There is a federal estate tax that can take a sizable bite out of your legacy, because it carries a 40 percent rate.
The exclusion is the amount that can be transferred tax-free, and the remainder is subject to taxation. Last year, the exclusion was $11.58 million, and it has been increased to $11.7 million in 2021 due to an inflation adjustment
There is a marital deduction that can be used to transfer unlimited property to your spouse tax-free, as long as your spouse is an American citizen.
A provision contained within the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (H.R. 4853) made the estate tax exclusion portable. This means that a surviving spouse can now use their deceased spouse’s exclusion.
If you are exposed to the estate tax, you would naturally consider lifetime gift giving as a response. People used to do this back in the early days of the estate tax, but a gift tax has been in place continuously since 1932.
The gift tax and estate tax have been unified under the tax code since the 1970s, so the $11.7 million exclusion that we have in 2021 is a unified exclusion. It applies to your estate and large gifts that you give during your life.
Annual Gift Tax Exclusion
Now that we have provided all the necessary background information, we can get to the ultimate point of this post. We used the qualifier “large” gifts at the end of the previous section because there is an additional annual gift tax exclusion.
You can use this exemption to give a certain amount to any number of gift recipients within a calendar year free of taxation. It is subject to change to account for inflation when a new year rolls around, so people were wondering if there would be an increase for 2021.
In fact, the annual per person exclusion will stay the same. Last year, it was $15,000, and it will be $15,000 in 2021.
There are a couple of other gift tax exclusions that you should be aware of if you have transfer tax concerns. You can use the educational exclusion to pay school tuition for others, and there is a medical expense exclusion as well, and it extends to the payment of health insurance premiums.
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