Many people have a plan in place for retirement but fall short of considering the impact of their finances after they die. If this is you, you’re not alone; on the contrary, you are among the millions of Americans who never take the time to prepare for what will happen to their finances after they pass away. Nearly half of older Americans don't even have a simple will. (1) Many fail to establish a will because the tax system includes a complex set of rules, such as inheritance, estate, and gift tax regulations, that can interfere with your wishes and assumptions about what will happen to your belongings when your life is over.
Below, you’ll learn how the inheritance tax works along with the fundamentals of estate taxes and how to reduce these tax liabilities legally. This information will help you better plan, ensuring your assets are protected and passed to your beneficiaries in a strategic and efficient manner.
What is an inheritance tax?
Inheritance taxes are assessed by individual states when the deceased person’s assets are disbursed. It is a tax paid by the person who inherits money or property from someone who has died.
Keep in mind that some states don’t have an estate tax or inheritance tax, and those that do may have different limits and exemptions for each. Now that you have the basic concept let’s discuss what could be subject to taxation.
What types of inheritances are subject to be taxed?
The types of inheritances subject to be taxed depend on the state. Most small inheritances are exempt from the inheritance tax if they fall below certain thresholds. For example, Iowa only assesses taxes on inheritances that are greater than $25,000. (2) Also, taxation on inheritances can vary depending on the type of property, such as physical goods like cars, real estate bequests, or retirement accounts like IRAs.
It’s important to note that each state has exemptions for certain people like spouses, immediate family members, and charities. Usually, more distant relatives are hit harder with higher inheritance tax rates compared with immediate family. Most inheritance tax states, except for Nebraska and Pennsylvania, don’t tax inheritances left to children.
What is the difference between an inheritance tax and an estate tax?
Many people erroneously think that inheritance and estate taxes are the same. However, while the inheritance tax is paid by the person who inherits assets from someone who has died, the estate tax is a levy on the actual estate itself of the deceased person. Estate taxes are reduced from the taxable estate and paid before the trustee, the person managing the trust, can distribute assets to the beneficiaries.
Another difference is that the state assesses inheritance taxes with the federal government charging estate tax. The federal estate tax rules are uniform throughout the country, while as we previously learned, estate and inheritance tax guidelines vary per state.
State estate tax and inheritance tax limits are much lower than the federal limits. The federal limits, which are also known as the unified credits, are $11.58 million for single filers and $23.16 million for married taxpayers. (3) Conversely, estate tax limits or credits can be as low as $1,000,000 per taxpayer, which means that smaller estates can face hefty tax bills.
How do I find out if my state has an inheritance tax?
Currently, only five states have an inheritance tax. The tax rates and the very existence of inheritance tax within specific states vary significantly. You can determine which states have an inheritance tax by checking here or consulting with a professional.
What can I do to reduce my inheritance tax liability?
Fortunately, there are a few simple strategies that you can implement to reduce your inheritance tax liability, as shown below legally:
Move to a different state
Moving to a different state that doesn’t have estate or inheritance taxes can be a wise move. Moving can also be a great way to reduce your general tax liability as seven states don’t have a state income tax. (4) For example, you can save on inheritance, estate, and state income taxes by moving to Texas.
Use the annual gift tax exemption
Consider persuading the person who would pass assets down to you to spread this gift out over several years. Each person can give up to $15,000 per year per person without worrying about estate or gift taxes. (5) Married couples can donate up to $30,000 to each person gift tax-free.
Trusts can be a powerful tool in your estate planning strategy as they organize your assets, protecting from creditors and probate. Probate is a long, expensive legal process that refers to when the government decides the fate of your estate. This occurs when people don’t prepare for estate planning by not implementing wills, beneficiary designations, or trusts.
Choose your beneficiaries wisely
Most states with inheritance tax provide exemptions for spouses, immediate family members, or charities. Consider leaving assets to these groups to reduce your inheritance tax liability. If you wanted to leave money to a distant relative, you could leave that money to your spouse, who could then use his or her annual gift exemption to donate funds to the distant relative.
Retirement account distribution strategies
Retirement accounts like 401(k)s and IRAs are subject to inheritance taxes when funds are distributed from these accounts. A surviving spouse could transfer funds from the deceased spouse’s IRA to his or her IRA without paying taxes.
However, regardless of the age of the surviving spouse or beneficiary, if the decedent was older than 72 in 2020 and had not taken their required minimum distribution (RMD), the government mandates an RMD would have to be taken by the beneficiary and taxes paid in that year for the distribution. (6) It doesn’t matter if the surviving spouse or beneficiary is younger than 72, he or she will still need to take the RMD during the year in which the inheritance was received.
Another strategy to mitigate RMDs is to use the single life method to calculate the RMD amount. This works if the surviving spouse is 10 years younger or more than the deceased spouse and reduces the annual RMD amount, which lessens the tax liability. (6)
Estate planning, inheritance taxes, and the like can be very intricate and challenging to navigate. Even though these systems are continually changing, planning is key.
Knowing how the inheritance tax works and the basics of estate planning will help provide more security for your family and reduce legal complexities. Having this fundamental information may allow you to reduce your estate/gift tax liabilities and pass along more of your hard-earned money and property to loved ones.
Robert "Fenn" Giles, Jr., MBA, CIMA® is a founding partner of Wealth Advisors of Tampa Bay (WATB) and acts as the firm’s President and Chief Investment Officer. WATB is an independent Registered Investment Advisor (RIA) located in Tampa, Florida. Learn more about them at wealthadvtb.com.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
This material was prepared by Crystal Marketing Solutions, LLC, and does not necessarily represent the views of the presenting party, nor their affiliates. This information has been derived from sources believed to be accurate and is intended merely for educational purposes, not as advice.
Wealth Advisors of Tampa Bay and LPL Financial do not provide legal advice or services.