We often respond to clients who have questions about how taxation can enter the picture when assets are changing hands after someone dies. This is certainly understandable, and perhaps surprisingly, most of the news that we pass along is good news.
Generally speaking, inheritances are not considered to be regular income for federal or state tax purposes. Plus, you get a step-up in basis if you inherit appreciated property. This means that for capital gains tax purposes, you are not responsible for gains that took place during the life of the person that left you the inheritance.
There is a federal estate tax in the United States that would apply to the taxable portion of an estate before it is transferred to the heirs. It carries a 40% top rate, so this tax carries a considerable wallop, but it does not apply to most families.
The reason why the majority of people do not have to pay the tax is because there is a significant credit or exclusion. This exclusion is the amount that can be transferred before the estate tax would be applied. In 2019, the exact amount of this exclusion is $11.4 million. You may see slightly higher figures year by year because of inflation adjustments.
Some states in the union have state-level estate taxes. In these states, the exclusions are usually lower than the federal exclusion. Because of this, it is possible for someone who is exempt on the federal level to face state-level estate tax exposure.
Here in Kentucky, there is no state estate tax so we are fortunate in that regard. However, if you own property in a state that has its own estate tax, it could be a factor depending on its value compared to the exclusion in that state.
Kentucky Inheritance Tax
It would be natural to assume that the term “inheritance tax” is just another way of referring to an estate tax. Though this make sense on the surface, they are actually two different forms of taxation.
An inheritance tax is imposed on transfers to each individual inheritor receiving a distribution who is not exempt, and as we have stated, an estate tax is applied on the entire taxable portion of an estate before it is distributed. There is no federal inheritance tax in the United States, but there are six states that have state-level inheritance taxes.
The odds are pretty good that Kentucky does not have one of these taxes, right? Unfortunately, we defy the odds in a bad way when it comes to this tax because the Bluegrass State is one of the six.
Under Kentucky tax laws, there are different beneficiary classes based on the familial relationship between the deceased person and the inheritors.
A surviving spouse, children, grandchildren, parents, and siblings are considered to be Class A beneficiaries for Kentucky inheritance tax purposes. Transfers to these relatives are completely exempt from the tax.
The Class B group consists of great-grandchildren, nieces, nephews, aunts, uncles, and daughters-in-law and sons-in-law. If you leave money to any of these relatives, there would be a $1000 exemption, and the rest would be taxed at a rate between 4% and 16%. The exact percentage would depend on the amount that is being transferred.
Anyone who does not fit into the Class A or Class B Category would be a Class C beneficiary. The exemption is just $500 for these individuals, and the rate starts at 6% and goes up to 16%.
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If you would like to learn more about taxation and other important estate planning issues, download our worksheet. It is being offered free of charge right now, and you can visit our worksheet access page to get your copy.
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