How to Avoid Inheritance Tax and Control Your Legacy

When it’s time for estate planning, one of the items on the agenda might be how to avoid inheritance tax. Estate planning can be an emotional process as one contemplates the best way to pass on assets to family and friends. Naturally, people want to avoid sticking their heirs with a daunting tax burden when they already are dealing with loss. The time to take care of that is while one is in good health and meeting with tax professionals and financial advisors

This article focuses on death, taxes and death taxes. It might seem gloomy, but isn’t it comforting to know how to place your assets where you choose and keep them away from tax collectors? 

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What is the inheritance tax?  

An inheritance tax is one that must be paid by a beneficiary (i.e, an heir) on assets received from an estate. Six states levy an inheritance tax; the federal government does not. This form of tax differs from the estate tax, although both are often called a death tax. The federal government and 12 states levy estate taxes, which the Internal Revenue Service defines as: “a tax on your right to transfer property at your death.” The tax is placed on the value of the estate and is taken before assets are distributed to heirs.  

How does inheritance tax work?  

Most states divide beneficiaries into different classes, based on their relationship to the deceased person. The states tax the groups at different rates and apply different thresholds, such as taxing only amounts over $50,000. As a rule, the closer the relationship to the deceased, the higher the exemption and the lower the rate a person has to pay. In all six states with inheritance tax, surviving spouses are exempt. In New Jersey, so are domestic partners. The only states where descendants aren’t exempt are Nebraska and Pennsylvania.  

The six states, with the highest rate charged, are:  

  • Iowa: up to 15% 
  • Kentucky: up to 16% 
  • Maryland: up to 10% 
  • Nebraska: up to 18% 
  • New Jersey: up to 16% 
  • Pennsylvania: up to 15% 

The inheritance tax is applied according to the location of the assets. To be subject to inheritance tax, someone either inherits assets from a person who lived in a state with the tax or inherited property located in a state with the tax. An heir does not have to live in a state to be subject to its inheritance tax. Also, the deceased person did not have to live in a state with inheritance tax for the state to levy the tax on property he owned there.  

For example, let’s say that John lives in Virginia, a state with no inheritance tax, and inherits his great aunt’s estate in New Jersey, where she lived at the time of her death. New Jersey would come calling for payment of its inheritance tax. On the other hand, if John lives in New Jersey and inherits an estate in Virginia, he pays no tax on his inheritance. He would have to pay tax, however, if a great aunt from Virginia (no inheritance tax) left him property in Pennsylvania, which has an inheritance tax.  

How Do You Pay Inheritance Tax?  

If the inheritance is money, an heir would send a check to the state tax authority. However, in most cases the executor of an estate calculates the tax due, subtracts what the beneficiary owes, and sends him a check for the balance. 

The most difficult burden for beneficiaries tends to involve the tax on tangible gifts, such as a car or house. They might not have money at hand to pay the tax. In fact, sometimes a grantor specifies in the will that the estate must pick up any inheritance tax owed by each beneficiary. 

Inheritance Tax vs. Estate Tax 

Both inheritance and estate taxes can apply when property transfers upon a death, which is why both are sometimes referred to “death taxes.” However, the two differ as to who pays the tax. The beneficiary pays an inheritance tax, while the estate pays the estate tax before distributions are made to heirs.   

The federal government, 12 states and the District of Columbia levy estate taxes. In 2021, the federal tax applied to estates worth $11.70 million or more, and the threshold for the 2022 tax year is $12.06 million. The states have their own thresholds.    

Maryland is the only state that collects both estate and inheritance taxes. It’s possible that an estate there would pay a federal estate tax and a Maryland estate tax, and then an heir would pay inheritance tax on the estate. 

The broader need for estate tax planning 

Clearly, more people need to plan for the estate tax than for the inheritance tax. The failure to plan can exact a steep price. 

For example, let’s look at a husband and wife aged 50 and 48, respectively. They sell their company and have a taxable estate worth $30 million. Assuming the estate grows at 5% per year, t would be worth $129,658,271 in 30 years. The estate tax is paid at the death of the second spouse. For 2021, the federal estate tax exemption for a couple was $23.4 million. The exemption for 2022 was set at $24.12 million. If the exemption remains in that neighborhood, about $23.8 million would be exempt and the taxable estate would be $105.86 million. The federal estate tax bill would be about $47.6 million. There also could be a state estate tax bill.   

A sound tax plan would shift some of these assets outside of their estate to shield it from estate taxes and to benefit their children and future generations. For example, a Dynastic Grantor Trust could keep wealth outside of all decedents’ respective estates for 365 years, if using trusts domiciled in Nevada or South Dakota.  

Estate planners and wealth management advisors also will warn high net worth individuals that the estate tax exemption is scheduled to be cut in half in 2026. Also, Congress could change any aspect of the estate tax when it chooses and create even bigger estate tax problems for those who have not adequately planned. 

How to avoid inheritance tax with a disclaimer 

A person can reject an inheritance through a process called disclaiming. The heir might choose this path to avoid negative tax consequences, because she wants it to go to the next beneficiary or for any reason she likes. The person needs to produce relatively simple paperwork and avoid receiving the inheritance or any benefit from it. The asset goes to the next beneficiary.  

Do I have to pay income tax on inheritance? 

The federal government doesn’t count inheritance as income, so there is no federal income tax on it. However, earnings, dividends, and capital gains can count as taxable income.  

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What is the best way to avoid inheritance tax?  

The real power here lies with the grantor when creating an estate plan. Beneficiaries have little control over inheritance taxes once they’ve inherited something. We will offer a few suggestions here, but they are meant only to begin a discussion. Consult a tax advisor or wealth management firm to discuss a proper course of action. 

Set up trusts  

A trust or trusts can be used in conjunction with a will. With a trust, a person gives a third party, a trustee or the trust itself, authority to handle his assets for the benefit of his beneficiaries. It allows the grantor to pass assets to beneficiaries after his death without having to go through probate. Avoiding probate protects privacy and helps beneficiaries avoid costly associated fees.  

Trusts can be set up to be either revocable – the grantor can add or subtract assets up until the time of death – or irrevocable, which locks all assets in place until the grantor dies. While inflexible, irrevocable trusts have great power in protecting an estate from taxes because it removes assets from an estate and might keep them from being classified as an inheritance. 

While it seems like a sensible tax strategy for a parent to place assets, like a home, into joint ownership with a child, this can actually lead to higher taxes for the child down the road. Why? Joint holders own the asset and the basis. To use a home as an example, if an heir was named a joint holder and later sold the home, taxes would be based on the gain in value from when the home was first bought to the present. If joint ownership had never been established, taxes from the sale of the house would be based on the value when it was inherited to the time of sale. That can be a very large difference.  

Use life insurance  

A grantor can take out life insurance and name beneficiaries who are subject to inheritance tax, leaving them enough money to cover the taxes. 

Give Away Some of Your Assets 

A person can give up to $15,000 a year to someone without it being subject to gift taxes. This allows loved ones the use of the money sooner and can thus reduce the amount of inheritance that might be taxed.      

Manage capital gains carefully  

Here are some strategies for reducing capital gains taxes on inherited property: 

  • Sell the inherited asset right away. You pay capital gains on the difference from when you inherited to when you sell, and this method allows little time for the value to grow. 
  • Establish it as your primary residence by living there for at least two years. A single filer can claim up to $250,000 of gains on their taxes for a primary residence.  
  • Use it as an investment property. 

Plan for the future  

Cope Corrales provides independent advisors, conflict-free proprietary investments and strategies for a wide range of financial needs. It’s just the kind of place one can go to find out how to avoid inheritance tax.  

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