When an estate is being transferred, the inheritors are receiving income in a sense, so people have questions about income taxes on bequests. In addition to this situation, you may have heard about estate taxes and inheritance taxes.
All this can get pretty confusing, and in this post, we will provide the facts so you can go forward with a renewed understanding of taxes on inheritances.
Income Tax and Capital Gains Tax
The assets that comprise your estate are left over after you paid taxes throughout your life. For example, if you put $100 out of every paycheck into an account that you are going to leave to your grandchildren, this would be coming out of your net income after you paid taxes.
If your grandchildren had to report their inheritances as taxable income, it would be two different rounds of taxation on the same income, and that would not be fair. As a result, direct bequests are not subject to regular income taxes.
This logic goes out the window if you can save considerably more than $100 out of every paycheck, but this is a matter that we will address in the next section.
The beneficiary of a living trust would not have to report distributions of the principal, but distributions of the earnings would be taxable.
With regard to inherited individual retirement accounts, you contribute into a traditional account before you pay taxes on the income, and Roth accounts are funded with after-tax income.
As a result, distributions from a Roth account are tax-free, and traditional account distributions are taxable. This arrangement also applies to the beneficiaries of individual retirement accounts when they take distributions.
If you inherit assets that appreciated during the life of the person that left you the inheritance, they would get a stepped-up basis. This means that you would not have to pay the capital gains tax on the gains that accumulated when the decedent was the owner of the assets.
Federal Estate Tax
There is a federal estate tax that carries a 40 percent maximum rate, so it can take a big bite out of your legacy. Even though it is an instance of double taxation, it is a fact of life.
The good news is that most people don’t have to pay the tax, because there is an $11.7 million exclusion. You can transfer this much tax-free before the estate tax would be levied on the remainder.
If you are married, you can use the unlimited marital deduction to transfer any amount of property to your spouse tax-free. The exclusion is portable between spouses, so a surviving spouse can use the exclusion that was earmarked for their deceased spouse.
New York State Estate Tax
New York is one of 12 states in the union with a state-level estate tax, so you could be forced to pay both taxes if you are quite wealthy. The New York exclusion is the highest among the states with estate taxes at $5.93 million.
There is also a strange provision that is unique to New York. If the value of your estate is at least 105 percent of the exclusion amount, the entirety of your estate would be subject to the estate tax.
There is no gift tax in our state (Connecticut is the only state with a state-level gift tax), but there is a three year clawback provision. Large gifts that you give within three years of your passing are considered to be part of your estate for tax purposes.
As we have stated, an estate tax is levied on the taxable portion of an estate before it is transferred to the heirs, so there is just one instance of taxation. An inheritance tax can be imposed on transfers to each individual inheritor that is not exempt.
There is no federal inheritance tax, and there are six states that have state-level inheritance taxes. Fortunately for us, New York is not one of them.
However, the states with inheritance taxes include our neighbors in New York and Pennsylvania along with Maryland, Kentucky, Nebraska, and Iowa. If you inherit property that is located in any of these states, their inheritance tax would apply to you.
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