Before we get to the increase in the estate tax exclusion, we should explain how taxes apply to inheritances in a broad sense. Many people assume that you are required to report an inheritance when you file your regular income taxes, but this is not the case.
Inheritance is not taxable income for a logical reason. Assets that comprise estates are left over after the decedents paid taxes throughout their lifetimes. For example, if a person saved a certain amount of money every pay period for 40 years, the accumulation would be an after-tax remainder.
For this reason, it would not be fair to tax the assets again when they are being transferred after the death of the person in question. Unfortunately, this very simple logic does not apply if the numbers get too big. Many people question this double standard, but it is a fact of life.
Another tax advantage that applies to asset transfers at death is the step up in basis. If you inherit assets that grew in value during the life of the person that left you the inheritance, you are not required to pay capital gains taxes on that appreciation.
Federal Death Tax
Income taxes do not apply to inheritances, but there is a federal estate tax. Most people do not have to pay the tax because there is a large estate tax exclusion or credit against the tax. The estate tax exclusion is the amount that can be transferred before this tax kicks in.
After tax cuts were implemented for 2018, the exclusion was set at $11.18 million. This was a huge increase over the previously existing figure of $5.49 million. Since then, there have been adjustments to account for inflation, and the 2020 figure stands at $11.58 million.
Regardless of the amount of assets, this tax does not apply to transfers between citizens that are legally married because there is an unlimited marital deduction. Plus, a surviving spouse can use the exclusion that was allotted to the deceased spouse.
Gift Tax
You cannot just give gifts while you are living to avoid the estate tax because there is a gift tax as well, and the two taxes are unified. The $11.58 million exclusion encompasses your estate along with large lifetime gifts.
There is an additional $15,000 per person, per year gift tax exclusion that allows you to give that amount to any number of recipients on an annual basis free of taxation. You can also pay school tuition for students without incurring any gift tax exposure, and there is an exemption for the payment of medical bills on behalf of others.
State Estate Tax and Inheritance Tax
Some states in the union impose their own state-level estate taxes. In these states, the exclusions are usually lower than the federal exclusion. Because of this, an estate could be taxable on the state level even if it is federally exempt. Our offices are in Kentucky and North Carolina, and there are no state estate taxes in these states.
There are a small handful of states in the union that impose inheritance taxes. Unlike an estate tax, an inheritance tax is not levied on the entirety of an estate before it is transferred. It can be applied to distributions to individual inheritors. As a result, multiple beneficairies could be subject to this tax when an estate is being distributed.
Unfortunately, there is an inheritance tax in Kentucky. That’s the bad news, but the good news is that close relatives like a surviving spouse, parents, children, grandchildren, and siblings are completely exempt.
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We have prepared a worksheet that you can use to learn more about the estate planning process. It is being offered free of charge, and we urge you to take advantage of this useful resource. You can get your copy right now if you visit our worksheet download page and follow the simple instructions.
John’s practice focuses on the use of Wills and Living Trusts in Estate Planning to help individuals protect their families and preserve their legacies after their deaths, but his practice also focuses on the critical issues of protecting individuals with dementia or other diminished capacity, assisting individuals in qualifying for Medicaid and other government benefits to offset the costs of long-term care, and providing special needs planning.
John is admitted to practice law in North Carolina, South Carolina, Kentucky, and Ohio, and he is accredited by the Department of Veterans Affairs.
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