Many people that speak with us about their estate planning concerns bring up the question of taxation right away. This is understandable, because it is natural to assume that taxes can have a significant impact on your legacy.
In this post, we will address these questions so you can come away with a more complete understanding of the subject.
If you are named in a will, do you have to claim the inheritance when you file your federal income tax return?
No, the inheritance would not be looked upon as taxable income by the Internal Revenue Service. This is because the person that left you the money paid taxes throughout their life, and their estate is comprised of assets that they were able to retain after paying their taxes.
Does this apply to life insurance policy proceeds?
Yes, if you are named as a beneficiary of a life insurance policy, the company will pay you directly as long as the policyholder died under covered circumstances. You would not be required to report the proceeds when you file your tax return.
How about capital gains taxes on appreciated assets that you inherit?
This is actually one of the most beneficial portions of the tax code when it comes to taxes on inheritances.
If you inherit assets that appreciated during the life of the person that left you the inheritance, you would get a step-up in basis. You would not be responsible for the gains that accumulated during the life of the decedent.
However, the meter would start running as soon as you are the owner of the assets. The capital gains tax would be applicable if you realize a gain at some point in the future. “Realizing a gain” is a fancy way of describing the act of selling an asset at a profit.
Do the beneficiaries of individual retirement accounts pay taxes?
Some of them do, and some of them don’t depending on the type of account that has been inherited. A traditional account is funded with pre-tax earnings, so the account holder must pay taxes on the distributions. The beneficiary would be in the same position.
Roth individual retirement accounts are funded after taxes have been paid on the income, so distributions to the original account holder are not taxable. This arrangement extends to the beneficiary as well.
Because of the fact that Roth individual retirement account beneficiaries do not have to pay taxes on the distributions, this type of account used to be ideal for estate planning purposes.
Beneficiaries are required to take mandatory minimum distributions on an annual basis, and the “stretch IRA” strategy was widely used in the past. The beneficiary would take only the minimum that was required by law for the maximum amount of time to take full advantage of the tax benefits.
The first SECURE Act that was passed at the end of 2019 put an end to the stretch IRA. Now, all the assets must be cleared out of either type of account within 10 years.
Will my family have to pay the federal estate tax?
The answer to this question depends on the value of your estate. There is a credit or exclusion that can be used to transfer a certain amount tax-free. The portion of an estate that exceeds the exclusion would potentially be subject to the tax.
At the time of this writing, it is $12.92 million, so a very small percentage of families are exposed to this tax. This figure is scheduled to go down to $5 indexed for inflation at the end of 2025.
There are some states that have state-level estate taxes. Fortunately, we do not have a state estate tax in Indiana.
If you own property in a state that has an estate tax, the tax in that state would be a factor if the property’s value exceeds the exclusion in that state. It should be noted that the state-level exclusions are typically quite a bit lower than the federal exclusion.
Schedule a consultation today!
A lot of people think that you can plan your estate without legal assistance if you don’t have to worry about taxation, but this is patently false. There are many approaches that can be taken, and the right choice will depend upon the circumstances.
Your estate plan should be custom crafted to ideally suit your needs, and we are in a position to provide the appropriate guidance. If you are ready to set the wheels in motion, you can call us at 219-865-2285 to set up a consultation at our Schererville, IN estate planning office. You can use our contact form if you would rather send us a message, and our Lafayette location can be reached by phone at 765-767-5225.
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