Understanding Inheritance Taxes and Federal Exemptions

Understanding Inheritance Taxes

Inheritance taxes, sometimes called estate taxes or death taxes, are taxes imposed on assets inherited after someone passes away. These taxes are separate from income taxes, and are based on the total value of the assets being transferred.

While there is a federal estate tax, as of 2023, only six states impose a state inheritance tax - Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Even if you live in a state with no inheritance tax, you may owe taxes on inherited property located in a state that does have one.

It's the executor's responsibility to file any necessary inheritance tax returns and pay the tax from the estate's funds. Taxes are due by the filing deadline for the federal estate tax return - generally 9 months after the date of death.

Inheritance taxes can significantly reduce the value of assets left to heirs. However, there are exemptions and strategies that can help minimize their impact. Understanding how they work is key to estate planning.

How Inheritance Taxes Vary by State

While the federal government imposes an estate tax on very large estates, inheritance taxes are state-level taxes. And the rules vary considerably between the states that collect them.

For example, in Nebraska, immediate relatives like spouses, parents, and children are exempt from inheritance tax. More distant relatives pay a 13% tax, while non-relatives pay 18%. But in Pennsylvania, taxes are owed by relatives as well, with rates ranging from 4.5% to 15%.

Tax rates can also vary based on the amount inherited. In Iowa, for instance, the tax rate ranges from 5% to 15% depending on the size of the inheritance and the heir's relationship to the deceased.

It's critical to check the specific laws in the relevant state, as they can change frequently. You may want to consult a local estate planning attorney or tax professional to understand the impact on your particular situation. But a little research can provide a general sense of what to expect.

Current Federal Exemptions for Inheritance Taxes

While the estate tax applies federally, there are substantial exemptions that mean most estates won't end up owing any federal estate tax.

For 2023, the federal estate tax exemption is $12.92 million. This means if the total value of the estate is less than this amount, no federal estate taxes are owed. This exemption amount is adjusted yearly for inflation.

There is also an unlimited marital deduction, meaning you can leave any amount to your spouse without generating a tax liability, as long as your spouse is a US citizen. There are also charitable deductions if you leave assets to qualifying charities.

Any unused portion of the exemption is "portable" between spouses. This means if the first spouse to die doesn't use up their exemption, the surviving spouse can use the leftover amount. This allows a married couple to collectively shield up to $25.84 million from estate taxes in 2023.

Even estates that exceed the exemption amount may be able to minimize estate taxes through careful planning. Strategies can include making annual tax-free gifts, setting up irrevocable trusts, and making charitable donations. An estate planning attorney can help devise a customized plan.

Determining if You Qualify for Inheritance Tax Exemptions

Whether you'll owe inheritance taxes depends on several factors, including:

• Your relationship to the deceased person. Most states exempt surviving spouses and children from inheritance taxes. Some states exempt other close relatives like parents and siblings as well.

• The value of assets you inherit. Each state has its own exemption amounts. Inheriting less than the exemption means no taxes will be owed.

• The type of assets inherited. Some states have special exemptions or valuation rules for certain types of assets, like family farms or small businesses.

• Any deductions claimed by the estate. The taxable value of the estate may be reduced by deductions like debts, funeral expenses, charitable bequests, and estate administration costs.

To determine your inheritance tax liability, you'll need to understand the specific laws of the state in question. The executor should be able to provide a list of assets you'll inherit and their values.

You can then research that state's inheritance tax rates and exemptions. But taxes on complex estates can get complicated quickly. Getting advice from an estate planning attorney is advisable before filing a return or making tax payments.

Tips to Minimize Your Inheritance Tax Burden

With some proactive planning, there are several ways to reduce the impact of inheritance taxes on your estate:

• Take advantage of annual gift tax exclusions. You can give up to $17,000 per recipient per year without triggering gift taxes.

• Create an irrevocable trust. Assets transferred to an irrevocable trust are removed from your taxable estate. You can set terms for how and when beneficiaries receive assets.

• Use the unlimited marital deduction. You can transfer unlimited assets to your spouse tax-free, if they are a US citizen.

• Make charitable donations. Leaving assets to charity can reduce your taxable estate while supporting a good cause.

• Move to a state that doesn't impose inheritance taxes. If you're considering a move anyway and have a sizable estate, factor inheritance taxes into your relocation plans.

• Create an estate plan. A comprehensive estate plan can incorporate a variety of inheritance tax minimization strategies tailored to your situation.

Start planning early if you want to minimize inheritance taxes. Many strategies, like gradual gifting and irrevocable trusts, work best when there's still plenty of time before the estate is likely to be transferred. Regularly reviewing your estate plan also ensures it stays up to date with changing laws.

Getting Additional Help with Inheritance Taxes

Inheritance taxes can be complex, with rules varying considerably between states. And the stakes can be high - mistakes can mean overpaying or underpaying taxes. Interest and penalties can accrue quickly on inheritance tax underpayments.

For that reason, getting professional help is often a good idea, especially for large or complicated estates. Consider consulting with:

• An estate planning attorney. An attorney who specializes in estate planning can assess your situation and recommend personalized inheritance tax minimization strategies.

• A tax professional. A CPA or enrolled agent can help clarify inheritance tax rules, prepare necessary returns, and ensure compliance with all filing and payment deadlines.

• A financial advisor. A financial advisor can help integrate inheritance planning into your broader financial plan and goals.

Many professionals offer brief no-cost initial consultations. These meetings can help you understand your options and decide how to proceed. The peace of mind that comes from knowing your inheritance matters are being handled properly is often well worth any fees.

Wrapping Up - Inheritance Tax Planning Next Steps

Spending some time learning about inheritance taxes now can save your heirs time, money, and stress later on. To get started:

1. Determine if you live in an inheritance tax state, or if you own property in one.

2. Get a rough sense of your estate's size. This will indicate whether you're likely to owe state or federal estate taxes.

3. Identify what inheritance tax exemptions might be available based on your location and heirs.

4. Consider strategies to reduce taxes, like annual gifting, charitable bequests, or trusts.

5. Consult an estate planning attorney, tax professional, or financial advisor for personalized guidance.

6. Take action on your preferred inheritance tax minimization strategies. Some approaches take time to implement.

7. Regularly review and update your plan as your financial situation and laws change over time.

With some proactive planning, you can preserve more of your estate for your loved ones or favorite charitable causes. And you'll gain the peace of mind of knowing you're not leaving your heirs with an unexpected tax bill in their time of grief.