Many people have questions about the way that taxes come into play when an estate is being distributed. It may be natural to assume that an inheritance would be looked upon as taxable income by the Internal Revenue Service. In a rare instance of good news as it applies to the tax man, generally speaking, direct inheritances are not subject to regular income taxes.
Another positive is the way that appreciable assets are treated when they are changing hands after someone dies. If you were to inherit assets that would otherwise be subject to capital gains taxes, you would get a step up in basis. This means that the value of the assets would be equal to their value at the time you took possession of them.
However, you would be required to pay capital gains taxes on future appreciation if you hold on to the assets and they do in fact go up in value. It should be noted that you would only be obligated to pay capital gains taxes if you liquidate the assets.
The Bad News
Now, we can move on to the bad news when it comes to taxes and asset transfers. There is a federal estate tax in the United States, and it carries a hefty maximum rate of 40%. That is quite a chunk, but there is a relatively robust credit or exclusion that allows you to bequeath a certain amount before the estate tax would be applicable.
At the time of this writing in 2019, the exact amount of the exclusion is $11.4 million. There are annual adjustments to account for inflation, so you may see a slightly larger number next year. To give you an idea of what to expect, in 2018, the exclusion was $11.18 million.
The estate tax can be applied on asset transfers regardless of the relationship that you have to the person that is receiving the bequest, with one exception. If you are married, and you and your spouse are citizens of the United States, you can utilize the unlimited marital estate tax deduction. This would allow you to transfer any amount of property between one another tax-free.
Another thing to understand about the estate tax as it applies to married people is the matter of portability. Prior to 2011, if you predeceased your spouse, your exclusion would die with you. The surviving spouse would only have one exclusion to apply to his or her estate.
Many people thought that this was patently unfair, because in almost all cases, both people would have contributed to the accumulation of a couple’s wealth. This changed when a piece of legislation was passed in 2011 that made the exclusion portable between spouses. A surviving spouse now has two exclusions to utilize.
State-Level Estate Tax
There are some states in the union that impose death taxes of their own. We do not have to contend with such a tax here in California. But, if you own valuable property in a state with an estate tax, it could be applicable. It should be noted that Hawaii has a state-level estate tax.
Federal Gift Tax
When you hear about the existence of the federal estate tax, you would naturally think about the possibility of lifetime gift giving to avoid the death levy. The estate tax was originally enacted in 1916, and people back then would take advantage of this loophole. However, in 1924, a gift tax was put into place to prevent folks from lifetime gifting as an estate tax avoidance method.
It was repealed in 1926, but in 1934, the gift tax was reenacted, and it has been a fact of life ever since then.
The gift tax is unified with the estate tax, so the $11.4 million exclusion that we have in 2019 applies to large lifetime gifts and the estate that will be transferred after you die.
There is a good reason why we used the qualifier “large” gifts above. There is an additional gift tax exclusion that sits apart from the unified exclusion. This is the annual gift tax exclusion that allows you to give up to $10,000 to any number of people within a calendar year free of taxation.
You are also allowed to pay medical bills for others without incurring any gift tax liability, and there is an educational exemption as well. If you want to pay school tuition for students, you will not be taxed for your generosity.
Download Our Free Estate Planning Worksheet!
If you would like to learn more about estate planning, download our worksheet. It is being offered free of charge right now, and you can obtain access to your copy if you click the following link: Free Estate Planning Worksheet.
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