Regular Income Taxes
Since you are supposed to report just about any type of income imaginable, a lot of laypeople would be ready to pay taxes on their inheritances. Fortunately, a direct inheritance is not subject to regular income taxes, and this would include life insurance proceeds. IRAs are a different matter, and we will discuss them in a future post.
Another advantage that you gain from a tax perspective that is built into the system is a step-up in basis. The best way to explain this rule is through the presentation of a simple example. Let’s say that your uncle bought 1000 shares of stock at $10 a share 20 years before he passed away. When you do the simple math, you find that he parted with $10,000.
During this 20 year period, the value of the shares went up to $100 each, and he leaves you the shares in his last will. He only paid $10,000, but they are now worth $100,000. The question is, would you be required to pay capital gains taxes on the increase?
Since inherited appreciable assets get a step up in basis, the answer is no. You would not be responsible for the gains that took place during the life of your uncle. However, if you hold on to the stock and it continues to grow in value, capital gains taxes would be applicable.
Federal Estate Tax
On the other side of the equation, there is a heavy form of taxation that can severely impact high net worth families. We have a federal estate tax in the United States, and it will consume $40 out of every $100 that is transferred after the exclusion has been exhausted. The estate tax credit or exclusion is the amount that you can pass along before the estate tax would kick in.
At the time of this writing in 2020, the exact amount of the federal estate tax exclusion is $11.58 million. A base of $11.18 million was installed for 2017, and there are ongoing adjustments to account for inflation, so you can expect to see a figure that is a bit higher next year.
This tax is applicable on transfers to anyone other than your spouse if you are married to an American citizen, because there is an unlimited marital estate tax deduction. If you are married to someone that is a citizen of another country, a qualified domestic trust can provide a solution, and we will look at that at another time.
State-Level Estate Taxes
There are 12 states with their own state-level estate taxes, and there is a separate tax in the District of Columbia. Our office is in Smithtown, New York, and we do have an estate tax in our state. The exclusion is $5.85 million this year.
Now we can hone in on inheritance taxes. If you are like a lot of people, you may look at the terms “inheritance tax” and “estate tax” as interchangeable. In fact, these are actually two entirely different forms of taxation. As we have explained, and estate tax is imposed on the entire portion of an estate that exceeds the exclusion before it is transferred to the heirs.
Things are different with an inheritance tax. This tax is levied on each bequest that is received by non-exempt inheritors. That’s the bad news, but there is some good news to go along with it.
There are only six states with an inheritance tax, and New York is not among them. There is no federal inheritance tax, and even in these six states, transfers between close relatives are typically exempt.
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