If you have been told that you will inherit from a loved one’s estate, you may be excited, but you may also have some concerns. If you are worried about the potential tax consequences, you probably don’t need to be. When it comes to inheritance, your tax obligation will depend on the applicable state law. When it comes to a federal tax on inheritance, it is not the person inheriting the property that is responsible. In fact, federal inheritance tax is more commonly known as estate tax. Here is what you need to know about inheritance tax in general.
What is the inheritance Tax?
The legal definition of “inheritance tax” is a tax imposed on money or assets received from the estate of another. The rate of the tax that is imposed depends on the type of beneficiary you happen to be. For example, spouses and lineal heirs (such as children) are typically taxed at a lower rate. In some cases, certain heirs are exempt from inheritance taxes altogether.
Does California impose an inheritance tax?
The federal government does not impose inheritance taxes. Instead, they are only imposed, if at all, on the state level. Not all states impose an inheritance tax, in fact, only a few states still do. Currently, only four states continue to impose inheritance taxes: Iowa, Kentucky, Nebraska, and Pennsylvania. Tennessee was the last state to eliminate inheritance taxes as of December 31, 2015. California eliminated its inheritance tax as of January 1, 2005.
How is inheritance tax different from estate tax?
The primary difference between estate taxes and inheritance taxes is who is responsible for paying the tax. Estate taxes are imposed on the deceased person, the person leaving the money or other assets to a beneficiary. The opposite is true for inheritance taxes, where the person inheriting or receiving the money or assets is responsible for paying.
How does the federal estate tax exemption work?
The federal estate tax exemption provides that an estate with a value below the exemption amount can be passed on tax-free. As of 2016, the exemption amount is $5.45 million. This estate tax exemption is “portable,” which means that the surviving spouse of a decedent can benefit from any unused portion of their deceased spouse’s exemption. The unused portion of the exemption is then combined with the surviving spouse’s own exemption.
What happens if my estate exceeds the annual exclusion?
Although most estates do not exceed the $5.45 million exclusion amount, there are certainly some estate that do. If your estate exceeds the exemption amount, an estate tax of 40 percent of the excess amount will be imposed. If you are married, though, you can take advantage of the unlimited marital deduction that is available for spouses. There are also a variety of other ways that you can avoid estate taxes through the use of estate planning tools.
Using the marital deduction to eliminate estate taxes
Married couples can give a gift of an unlimited amount to each other. The value of the property gifted to the surviving spouse is subtracted from the deceased spouse’s estate. Because all assets go to the surviving spouse, there are no estate taxes imposed. A married couple can in effect protect $10.9 million from federal estate and gift taxes. This is most commonly referred to as the lifetime credit.
What is the “generation skipping” tax
The “generation skipping” tax is yet another type of estate tax you should be familiar with. This is a tax assessed on any assets passed on to a generation that is two or more levels below the decedent. In other words, when you leave property to your grandchildren, as opposed to your children, the IRS will assess the generation skipping tax. This particular tax also applies to a transfer of property to someone who is unrelated to you and who is 37 ½ years or more younger than you.
Generation-skipping trusts can be useful
The purpose of a General Skipping Trust is to minimize or avoid estate taxes on transfers made to subsequent generations. This is accomplished by holding the assets in trust and distributing the funds in a pre-defined way, to each successive generation. In this way, the entire amount of the trust is protected from estate taxes with each passing generation. A common misconception is that Generation Skipping Trusts are only for wealthy families, but most families can benefit from this type of estate planning.
The benefit of making gifts instead of inheritances
Another way to avoid California estate taxes is by transferring property to your grandchildren or other heirs as gifts instead of inheritances. This will reduce the size of your estate, as well as decrease the amount of taxes imposed on your estate upon your death. For example, grandparents can give their grandchildren up to $14,000 each year (or $28,000 if they combine their gifts) to each grandchild, without incurring a gift tax. There are several options, actually. You can make an outright gift, pay health care or education expenses, put the money in a custodial account, or transfer the money into a trust.
Download our FREE estate planning checklist! If you have questions regarding inheritance tax, or any other estate planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.