When money is changing hands, the tax man will usually want a piece of the action. Given this reality, people have questions about how taxation can impact inheritances. We will provide some answers to some of the typical questions that we hear in this blog post.
Do you have to report an inheritance on your income tax returns?
The answer to this question is generally no, and this is surprising to many people. An inheritance is not considered to be taxable income because the person that left you the money paid taxes throughout their life. Their estate is a remainder that was left over after taxes were paid. Pre-tax retirement plans and annuities are exceptions to this rule.
Does this apply to life insurance proceeds?
Yes, the money that is paid out by the insurance company usually would not be looked upon as taxable income by the Internal Revenue Service.
How about individual retirement accounts?
That is a question with a multi-leveled answer. If you have a Roth individual retirement account, you make contributions after you pay taxes on your income. Because of this arrangement, the beneficiary would not have to pay taxes on distributions.
The reverse is true when it comes to traditional IRAs. The deposits into the account are pretax contributions so the distributions are considered to be taxable income when you take then out of the inherited IRA.
Another big exception to the general rule is annuities. If an annuity is not an IRA, the amount the annuity grew by is taxable; the premium used to purchase the annuity is not taxable.
How does the IRS handle other inherited assets that appreciated during the life of the decedent?
For capital gains purposes, you get a step up in basis if you inherit appreciated assets. You would not be responsible for gains that occurred during the life of the person that left you the resources.
However, if you keep the assets and they continue to grow, you would be responsible for future gains when they are realized (when you sell the asset).
So there is no estate tax at all?
The answer to this is yes and no. There is a federal estate tax in place that is separate from the income tax, and it carries a 40 percent maximum rate. The reason why we can say yes or know is because the tax does exist, but most people do not have to pay it.
This is because there is a high federal estate tax credit or exclusion right now. During the 2020 calendar year, the exclusion is $11.58 million. This amount can be transferred tax-free, and anything that is transferred that exceeds this figure would be subject to taxation.
Some states in the union have state-level estate taxes. In these states, the exclusions are typically lower than the federal exclusion. Because of this arrangement, someone could be exposed to a state estate tax even if they are exempt from the federal estate tax.
Our offices are in Kentucky and North Carolina. These states do not have their own estate taxes.
Is there any other tax that can apply to an inheritance?
A small handful of states have state-level inheritance taxes. It may sound strange, but an inheritance tax and an estate tax are two different things. An inheritance tax is levied on transfers to individual inheritors.
As a result, there can be multiple impositions of the tax when one estate is being administered.
There is no inheritance tax in North Carolina, but there is an inheritance tax in Kentucky. That’s the bad news, but the good news is that Class A beneficiaries are completely exempt. These would your surviving spouse, parents, children, grandchildren, and siblings.
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