The IRS is interested in getting its hands on any income that is received from any source. This can lead you to believe that inheritances are taxable. Getting to the truth is a complicated. This legal guide offers some clarity on the subject.
Regular Income Taxes
A direct inheritance that is received through the terms of a will is not considered to be taxable income by the IRS or the state tax authorities. This also applies to the death benefit of life insurance policies.
If you are the beneficiary of a living trust, distributions of the trust principal would not be taxable, but the distributions of the earnings from assets held by the trust during the administration period would be subject to taxation. Unless distributed to the beneficiaries, the trust itself would be required to pay taxes on undistributed interest income.
You can make pre-tax contributions into a traditional individual retirement account (“IRA”). However, distributions are taxable. This applies to the original account holder as Required Minimum Distributions are received. And it also applies to the beneficiary who would receive the balance of your IRA upon your demise. One hundred percent of distributions – either RMDs or a lump sum distribution – are taxable as ordinary income.
By contrast, Roth accounts are funded with after-tax earnings, so distributions to the original account holder and the beneficiary are received income tax-free.
Capital Gains Tax
The capital gains tax is a factor if you sell assets after they have appreciated. This is called “realizing a gain” in tax parlance.
There are two different rate structures depending on the type of gain that is realized. Short-term gains that were realized less than a year after acquiring an asset are taxed at your regular income tax rate.
For long-term capital gains, there is a graduated rate depending on your income level. Individuals in the lowest brackets are completely exempt from capital gains tax. Most people would pay a 15 percent rate. The long-term rate for the highest income earners is 20 percent at the time of this writing.
If you inherit assets that appreciated during the life of the person who left you the inheritance, the assets will receive a stepped-up tax basis in that asset. You would receive a new tax basis (cost) equal to the fair market value of the asset at the time of the decedent’s death. The decedent’s gain disappears. If you sell the asset for that same fair market value, you will pay no capital gains taxes.
Federal Estate Tax
We have a federal estate tax in the United States, and it carries a 40 percent top rate. The exclusion is an amount that you can transfer tax-free to any person. The estate tax would be levied on any amounts in excess of the amount excluded.
At the time of this writing, the estate tax exclusion is $11.7 million. A provision is the law stipulates this exclusion amount is reset to $5.49 million adjusted for inflation from 2011 on January 1, 2026.
What about transfers to a spouse? There is an unlimited marital deduction provision in the law meaning you can leave an unlimited amount to your spouse tax-free. Even $1 trillion. Of course, your gift plus the spouse’s separate assets above the exclusion at the spouse’s death would be subject to the estate tax. This deduction from your taxable estate only applies to American citizens. A qualified domestic trust can be used to gain estate tax efficiency if you are married to a citizen of another country.
Federal Gift Tax
The estate tax and gift tax are unified today. That means you cannot give large gifts to avoid the estate tax. Any lifetime gift will be brought back into your taxable estate. The $11.7 million exclusion applies to your estate and any gifts you make while you are living. There are some exceptions.
There is an annual $15,000 gift tax exclusion. It can be used to give this much annually to any number of people. To be clear, there is no limit on the amount you can give if no gift recipient receives more than $15,000.
Another exclusion allows you to pay school tuition for students without incurring any gift tax liability. It is a tuition-only exclusion that does not extend to other expenses, but you can use the $15,000 annual exclusion to provide added support.
If you want to pay medical bills or health care insurance premiums for others, you will not be taxed for your generosity, because there is a medical expense exclusion.
State-Level Estate Tax
We do not have a state-level estate tax in Oklahoma, but there are 12 states that have their own estate taxes. If you own valuable property in one of these states, your estate would not be exempt if its value exceeds the exclusion in that state.
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