People often wonder about taxation as it applies to postmortem asset transfers. Since all different sources of income are supposed to be reported, it would be logical to assume that you would be required to let the IRS know that you have received an inheritance. In fact, this is not the case at all.
If someone names you in a last will, or if you are the beneficiary of a trust, you do not have to pay taxes on the windfall. The same thing is true if you inherit an individual retirement account, and insurance policy proceeds are not considered to be taxable income by the Internal Revenue Service.
Federal Estate Tax
The above being stated, if you have experienced a lot of financial success financially, you have to be concerned about the federal estate tax. It is only a factor for high net worth individuals because there is a credit or exclusion is relatively high. The exclusion is the amount can be transferred before the estate tax would be levied.
Back in 2011 a tax reform act was passed, and it set the estate tax exclusion at $5 million. There was another piece of tax legislation passed a couple of years later, but the base exclusion was retained with ongoing adjustments for inflation. This arrangement remained in place through 2017, when the estate tax exclusion was $5.49 million.
During that year, tax cuts were enacted by Congress and signed into law by the president. One provision contained within the measure increased the amount of the federal estate tax exclusion. At the time of this writing in 2019, it stands at $11.4 million.
Each individual taxpayer gets this exclusion, so if you are married, you and your spouse would have a combined exclusion of $22.8 million. Plus, the exclusion is portable. This means that your surviving spouse would be able to use your exclusion along with his or her own if you pass away first.
Speaking of the estate tax and spouses, there is an unlimited marital estate tax deduction. This allows you to leave any amount of property to your spouse free of the estate tax, as long as you and your spouse are American citizens.
There is an estate planning device that can be utilized to gain estate tax efficiency if you are married to someone that is not a citizen of the United States. We will explain that estate planning tool in a different blog post.
Federal Gift Tax
In addition to the federal estate tax, there is also a gift tax that is in place to stop people from giving gifts in an effort to avoid the death levy. The exclusion is a unified exclusion that encompasses your estate and significant lifetime gifts that you give to others. As a result, if you use all of your exclusion giving gifts tax-free, there would be nothing left to apply to your estate, and all of it would be taxable.
State Level Estate Tax
Some states impose estate taxes on the state level. In many cases, the exclusions are lower than the federal exclusion. As a result, someone that is exempt from the federal estate tax could be exposed to a state death tax. We practice in Michigan, and there is no state estate tax here. However, if you own property in a state that does have an estate tax, that tax could be a factor for you.
You may assume that the term “inheritance tax” is just another way of describing the estate tax. This is a common misconception, but in reality, these are two different forms of taxation.
An estate tax is applied on the entire taxable portion of an estate before it is transferred to the heirs. On the other hand, an inheritance tax can be levied on each transfer to different respective inheritors. There is no federal inheritance tax, but there are a few states that have state inheritance taxes. Fortunately, Michigan is not one of them.
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