Death is inevitable for all of us, yet it doesn’t make the process any easier when you must say goodbye to a family member or close friend. Receiving an inheritance is one way a deceased member of the family can thank and reward those he or she cares about the most, one last time.
Getting an inheritance is a good thing for those receiving it. However, there are tax liabilities when it comes to dealing with inheritance and the IRS. How do you minimize taxes on an inheritance?
Types of Taxes Related to Inheritances
Getting a family inheritance feels like hitting the jackpot for some individuals. However, it is important not to get too excited or act too quickly. It can lead to expensive missteps you might have avoided with the IRS.
An inheritance can include anything from direct cash payments to receiving investments to property. The good news is that inheritances are not considered income for federal tax purposes.
However, any subsequent earnings on the inherited assets are taxable unless it comes from a tax-free source. For example, selling inherited investments (like property) is usually taxable, yet you can also claim losses from these types of sales.
There are three primary types of taxes heirs who are traditionally liable for taxes on inheritances. They are:
● Inheritance Tax: Taxed on the property you inherit from a decedent.
● Estate Tax: Taxed on the value of the decedent’s property.
● Capital Gains Tax: Taxed on the proceeds that arrive from the sale of a property.
Inheritance tax and capital gains tax are covered by heirs on a personal return. The estate tax is covered by the estate, but may reduce the value of the inheritance.
Federal Level Taxes
The federal government is surprisingly not too invasive when it comes to taxing an inheritance. It only cares about any capital gains tax you may owe. Therefore, an inheritance is not subject to income tax.
You may have to report federal income taxes based on the type of property you inherit. For example, those who inherit a traditional 401(k) or IRA will need to include all the distributions taken out of the account in an ordinary tax return.
Inheritances, and how they are taxed, are different depending on where you live. Currently, only six states collect inheritance tax (Iowa, Maryland, Kentucky, Nebraska, Pennsylvania, and New Jersey).
Regardless, property that passes to a surviving spouse is exempt from inheritance tax in every state. Additionally, Pennsylvania and Nebraska are the only two states that collect inheritance taxes on property which passes from children to grandchildren.
Capital Gains Tax
Capital gains tax is applied based on the difference between the value of an asset and the amount it is sold for. As a result, if you sell for less than its value, then you don’t owe capital gains tax. However, if it is sold for more than its value, you are taxed on the difference.
The good news is that the long-term capital gains tax rate is traditionally more forgiving to taxpayers compared to the regular income tax brackets. As a result, inheritances typically qualify for the lower long-term rate, which should help with tax liability.
Avoid Paying Taxes on Inheritances
There are a few simple ways to reduce taxes you owe related to an inheritance, including the pesky inheritance tax:
● Give away assets before you pass away. Most states do not tax gifts after you perish.
● Gifts can go to heirs in many different ways, not just cash. A couple of examples are stocks and bonds.
● Use caution with inherited assets that appreciate. You may need to pay capital gains tax once you sell the assets.
● The capital gains tax rate is based on the profit you earn. Selling assets for more money usually means higher taxes.
● Inheritances like 401(k) and IRA accounts are notorious for creating taxable income you must report.
● Keep in mind where you live. Some states like Nebraska, Maryland, and Pennsylvania tax inheritances much more severely.
You may also want to take steps to protect yourself like considering an alternate valuation date, putting everything into a trust, or minimizing retirement account distributions.
Protect Your Family’s Inheritance from High Taxes
Unfortunately, handling an inheritance is complicated and may lead to serious taxes. It is important to employ the help of an experienced professional to make sure the estate gets taken care of correctly.
Contact Levy & Associates at 800-TAX-LEVY or visit www.levytaxhelp.com. Levy & Associates has years of experience working with family estates and reducing tax liability on inheritances. Every situation is unique. Meet with us for a free initial consultation for more details.