There are few words in the financial dictionary that can be as loaded to readers as inheritance. This word can mean quick riches for some, agonizing family splits and legal wrangling for others and tedious and inconvenient estate settlement paperwork and court filings for those who are nominated as executors and trustees .
But anyone who either comes into an inheritance or is involved in processing one must contend with the tax man one way or another. There are several different kinds of inheritance taxes and the first step in filing and paying them correctly lies in knowing which ones will apply. (For more, see: Getting Started on Your Estate Plan .)
This type of tax will only apply for non-spouse designees who expect to receive an inheritance from the deceased that exceeds $5.43 million in value in 2015. Furthermore, Congress has elected to make the unified credit portable for married couples, so one spouse can now leave their entire fortune to the other, and the other can then use both his or hers and the previously deceased spouse’s unified credits to distribute up to $10.86 worth of assets in 2015.
Example. Joe and Betty each have $7 million dollars in their individual retirement accounts (IRAs). Joe dies in March of 2015 and leaves all of his IRAs to Betty. No estate tax is due at this point because of the unlimited marital and charitable deduction. Betty dies that fall and leaves the entire $14 million worth of IRA money to their two children. The first $10.86 million of IRA money will pass tax-free to the kids, regardless of how this is allocated, and the remainder will be taxed at the current estate tax rates. Federal estate taxes are filed using Internal Revenue Service (IRS) Form 706. (For more, see: 4 Ways to Minimize Estate Taxes .)
Estate taxes may also be imposed at the state level if the decedent’s estate exceeds the limit imposed by that state. This amount varies by state, but the threshold is usually considerably lower than the federal limit. The rules that apply if the decedent owned substantial property in other states may be rather complex in some cases. There are currently 16 states that impose an estate tax, and Tennessee will no longer be one of them as of Jan. 1, 2016.
If the decedent of an estate made a gift of cash or property to someone other than his or her spouse or a qualified charity in the year of death, then a gift tax return will have to be filed and tax paid on the amount of the gift that exceeds $14,000 for 2015. This task is typically assigned to the executor of the estate, although a tax professional is often then delegated to perform the actual service. (For more, see: What Are Gift Taxes? )
Example. Eric gives $20,000 in cash to his girlfriend Ida in February 2015. Six months later he is killed in a car crash. He will owe gift tax on $6,000 of the cash he gave his girlfriend for 2015. The executor of his estate requisitions his former income tax preparer to file the return for this. Federal gift tax returns are filed using IRS Form 709. As with estate taxes, there can be gift taxes imposed at
the state level, and multi state gift tax returns may need to be filed for property that was gifted in a nonresident state.
Unlike the previous two types of taxes, inheritance taxes are only assessed at the state level. There is no federal inheritance tax per se. And fortunately for most taxpayers, there are now only six states left in America that assess an inheritance tax for current tax years. Nebraska, Iowa, Kentucky, Maryland, Pennsylvania and New Jersey still impose this tax on inheritances. (For more, see: Leaving Inheritance to Children Easier Said Than Done .)
This type of tax is unique in that it is not triggered by the amount of the bequest, but rather by the relation of the recipient to the deceased. Spouses are unconditionally exempt from inheritance tax in all states, and most charities are also exempt with a few exceptions. Kids are usually either exempt or are taxed at a very low rate. The tax rates start to climb for more distant relatives or non-relatives. The inheritance tax is also usually assessed on anyone who receives property that was located in one of the above states, regardless of where the recipient lives. An heir who lives in Idaho and inherits his grandmother’s house in New Jersey will be required to pay the appropriate amount of inheritance tax.
Inheritance tax rates can vary substantially from one state to another and one type of relative to another. However, only one inheritance tax form typically needs to be filed to cover all taxes that are owed by all heirs for assets that go through probate. The executor is often required to present the filed form to the probate court in order to prove that this tax has been paid before the court will release the property to the heirs. The beneficiaries are responsible for filing returns for any eligible assets that are received outside of probate, such as life insurance benefits, retirement plans, annuities and transfer on death (TOD) accounts. (For more, see: Skipping-Out on Probate Costs .)
The last type of tax that may be owed by heirs or estates is, of course, the income tax. This will be assessed on any income that was earned by the decedent between the date of death and January 1 of that year. In some cases, the heir may owe tax on the sale of securities held in taxable accounts or other property depending upon the timing and circumstances of the sale. Any income that the decedent would have received had he or she lived must also be taxed, such as a final paycheck or investment income. Tax must be paid on this type of income by either the estate, the heir or anyone else who would have received it.
The Bottom Line
There are several different types of taxes that may apply to a given inheritance. More than one of them will often be assessed for many heirs, and those who are fortunate enough to inherit property need to make sure that Uncle Sam and all respective states get their share before claiming what is left. For more information on gift, estate and inheritance taxes, visit the IRS website at www.irs.gov or consult your financial advisor. (For more, see: Estate Planning 16 Things to Do Before You Die .)