When you are entering into the estate planning process, you will invariably consider the matter of taxation. We are going to look at the capital gains tax per se in this post, but before we focus on that specific tax, we will share some broader information about the way taxation can impact inheritances.
Income Taxes
A lot of people are pleasantly surprised when they hear that you do not have to claim an inheritance when you file your state and federal income tax returns. This applies to insurance policy proceeds along with direct bequests.
Contributions into a traditional individual retirement account are made before taxes are paid on the income. As a result, the distributions are taxable. This arrangement applies to the original account holder and the beneficiary.
The tax situation is reversed when you have a Roth IRA. Money is deposited into the account after taxes have been paid, so distributions to account holders and beneficiaries are not subject to taxation.
Estate and Inheritance Taxes
An estate tax is levied on the portion of the estate that exceeds the exclusion or credit. To be clear, there would be just one imposition of the tax before the heirs receive their inheritances.
There is a federal estate tax with a 40% top rate, but you probably do not have to pay it, because the exclusion is $11.58 million. Some states have state-level estate taxes, but California is not among them.
It would be logical to assume that the terms “inheritance tax” and “estate tax” are interchangeable, but this is not the case. Unlike an estate tax, an inheritance tax can be applied on distributions to each individual inheritor when one estate is being administered.
We do not have a federal inheritance tax in the United States, and there are just a half a dozen states that have state-level inheritance taxes. Once again, California residents are in the clear, with one caveat.
If you inherit property in a state that does have an inheritance tax, the tax in that state would potentially be applicable. The same is true for a state-level estate tax.
Capital Gains Tax and the Step-Up in Basis
Now that you understand the other taxes, we can get to the capital gains tax. When appreciated assets are transferred to an heir, the inheritor would get a step-up in basis when it comes to the capital gains tax. The beneficiary would not be responsible for gains that accumulated during the life of the decedent.
Going forward, the inheritor would be responsible for future gains if and when a gain is realized.
The step-up in basis can be used to great advantage when you are planning your estate if you are in possession of appreciated assets. Many existing state plans include the utilization of this strategy.
We have an election coming up in the near future, and Democratic candidate Joe Biden has proposed an elimination of the step-up in basis. If he wins and he has congressional support, this could very well become a reality. This is something to keep an eye on if a change would impact your estate planning objectives.
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