Uncle Sam always wants a slice of your pie, so you have to report income from all sources when you file your tax returns. This can lead to the belief that an inheritance would be taxable income.
Do you really have to report an inheritance to the IRS? We will answer the question in this post, and we will provide a general overview of the way that taxes can impact inheritances.
If you save money after you get paid, you are putting away cash that is left after you paid your taxes. After your passing, if the savings are passed along to an heir, they would not be required to report an inheritance to the IRS because they are inheriting after-tax earnings.
This being stated, in some cases, a person will inherit assets before taxes have been paid on the income. Distributions of the earnings that are generated by assets in a trust would fall into this category, and there is also the matter of traditional IRA beneficiaries.
Contributions into a traditional individual retirement account are made before taxes are paid on the income, so the distributions to the account holder are taxable. This also applies to the beneficiary of a traditional IRA.
Capital Gains Tax and the Stepped-Up Basis
Let’s assume that you inherit stock from your grandfather that is worth $150,000. He paid $50,000 for the shares, and they appreciated by $100,000 when he was in possession of them.
Would you as an inheritor be required to pay capital gains tax on the $100,000 gain? The answer is no because the assets would get a stepped-up basis. For tax purposes, the basis would be $100,000, and you would only be responsible for future capital gains that are realized.
“Realizing a gain” is the act of selling an asset that appreciated while you were in possession of it.
Federal Estate Tax
As we have stated, the IRS and the state tax authorities do not tax the same income twice by forcing people to claim inheritances as taxable income because it would not be fair. For some reason, this logic does not apply to people that have accumulated significant wealth.
There is a federal estate tax that carries a 40 percent maximum rate, but it is only a factor for high-net-worth individuals because of the exclusion. This is an amount you can transfer tax-free before the tax would become applicable, and it is $12.92 million this year.
If you are married, you can use the unlimited marital estate tax deduction to transfer any amount of property to your spouse in a tax-free manner. There is a stipulation with regard to American citizenship, so you cannot use the deduction if you are married to a foreign citizen.
Since 2011, the estate tax exclusion has been portable. This term describes the ability of a surviving spouse to use the exclusion that was allotted to their deceased spouse.
Federal Gift Tax
You cannot give large lifetime gifts to sidestep the federal estate tax because there is a gift tax, and the two taxes are unified. The $12.92 million exclusion applies to gifts that you give while you are alive and the estate that will be transferred after your death.
There is an additional $17,000 annual exclusion that you can use to give gifts without utilizing any of your unified lifetime exclusion. Each taxpayer can give this much to any number of gift recipients every calendar year without incurring any transfer tax exposure.
If you want to pay school tuition for others, you would not be taxed, but you have to pay the institution directly. This exemption applies to tuition only, but you can use your $17,000 annual exclusion to provide some added financial support
Another exemption is in place for the payment of medical bills for others, and it extends to health insurance premiums.
Generation-Skipping Transfer Tax
The generation-skipping transfer (GST) tax is a federal tax that applies to transfers of wealth made directly to a grandchild or anyone who is at least 37.5 years younger than the donor. The tax is designed to prevent families from avoiding estate and gift taxes through long-term trusts or other wealth transfers spanning multiple generations.
State-Level Estate and Inheritance Taxes
In addition to federal transfer taxes, there can also be state-level estate taxes. Overall, there are 12 states in the union that have these taxes, and the exclusions are typically lower than the federal exclusion.
We practice in the state of South Carolina, and there is no estate tax in our state. However, if you own property in another state that has an estate tax it would apply to your estate. Of course, this would only be a factor if the value of that property exceeds the exclusion in the state.
As we have explained, an estate tax is levied on the entire taxable portion of an estate before it is split up and distributed. An inheritance tax is a tax that can potentially be applied to transfers to each inheritor when an estate is being administered.
There are six states that have inheritance taxes, and once again, we are in the clear in South Carolina. But, if you inherit property that is located in one of the states, the tax could apply to you.
If you own property out of state, or if you will be inheriting property that is located in another state, you should look into the laws.
Take Action Today!
Today is the day to act if you are going through life without a plan, whether you have to report an inheritance to the IRS or not. You can send us a message to request a consultation appointment, and our Bluffton, SC estate planning office can be reached at 843-815-8580.
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