Death-Related Taxes That Can Be Avoided
The term “death taxes” refers to two separate but related taxes. The first is the estate tax, which is imposed on the total value of the estate – everything owned by the deceased at the time of death. The second is the inheritance tax, which is imposed on each individual inheritance passed from the estate to the beneficiary.
Giving Money to Avoid Taxes
You can also give some of your money as gifts to your loved ones each year. As long as you give less than the annual gift tax exclusion limit, you won’t have to pay taxes. You can transfer a large amount of money to beneficiaries without paying a gift tax if you do it every year over a long period of years, thus reducing the overall value of your estate at the same time.
How Living Wills Work with Your Estate
Living wills are legal entities that hold the property which will ultimately be transferred to living beneficiaries at the time of the testator’s death. Living wills avoid the probate process but not necessarily the estate-related taxes. There are two basic types of living wills.
Avoiding Taxes Using Retirement Accounts
Retirement accounts can be complicated for your beneficiaries. Distributions from these accounts are usually taxable, and the tax laws are strict about when distributions must occur if you leave your accounts to anyone other than your spouse. If you leave your retirement account to your spouse, they can simply take over responsibility for it. They won’t have to start taking the required minimum distributions and paying taxes on those distributions until they reach age 72. The account will be treated as if they owned it personally all along.
Unlimited Spousal Exemption
All of these rules assume that you are not giving direct assets to your spouse, either during your life as gifts or upon your death as part of your estate plan. It protects spouses with an unlimited spousal exemption. You can give everything you own to your partner, or leave everything to them in your estate plan, and no tax will be imposed – with one exception.
How Capital Gains Taxes Work on Inheritances
Gifts to beneficiaries typically are not taxed as income to them, but that doesn’t necessarily mean they won’t be subject to capital gains tax. Let’s assume this hypothetical scenario: you leave your family home to your friend. You paid $80,000 for it decades ago. It’s worth $400,000 at the time of your death. Depending on where your home is located, the state may want a percentage of that $400,000 as estate tax.
Your friend has their own home and doesn’t want to sell it and move back to yours. They also don’t want to rent it out and deal with it as a landlord, so they decide to sell it. The capital gains tax is typically due on the difference between the basis of the asset – what it cost you to acquire – and the final sale price.
If your friend sells the house for $400,000, the capital gain would be $320,000, and they may have to pay capital gains taxes on that amount. They may not realize any profit, however, if you are passing the house to them as part of your estate plan after your death. The basis is “stepped up” to the fair market value at the date of death for inheritances. They won’t realize any gain if the property is worth $400,000 at your date of death, and they decide to sell it for that value.
The basis remains at the purchase price – $80,000 in this example – if you transfer ownership to your living trust rather than giving it directly to your beneficiary.
Your living trust executor can choose an alternate date to calculate any estate taxes that may be due. This date is six months after your date of death. This value will be the stepped-up basis for your assets. It will benefit your beneficiary if the property appreciates slightly during that time.
Questions
The Inherited
What is the estate tax rate?
The federal estate tax ranges from 18% to 40% on the taxable portion of estates exceeding a specified annual threshold. There is no federal inheritance tax for beneficiaries. State tax rates range from 0% to 16% for both types of taxes.
Where should inheritance be reported on the tax return?
You are not required to report inheritance income on your federal tax return, although you will need to report any income generated from inherited funds on the relevant tax forms with Form 1040. For states that impose inheritance taxes, such as Kentucky, you will typically need to file an inheritance tax return.
Source: https://www.thebalancemoney.com/best-ways-to-protect-your-inheritance-from-taxes-4178488
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