The death of a loved one is often a very emotional and stressful experience. That stress can be compounded by concerns about finances. One common concern is understanding what is owed in taxes on the financial assets that are left behind. Consulting with an estate planning professional is best, but here are some fundamental concepts about taxes on inherited assets that can help allay your concerns.
Income taxes take a back seat
Most of us are familiar with the concept of income taxes. It is the tax on the income we earn on our jobs and therefore the tax we worry about the most. In helping one client deal with the death of her mother, she expressed fear that her mother’s assets would be added to her income for that year and therefore would increase the amount she would have to pay in income taxes.
She was relieved when I told her that estate tax rules are different from income tax rules and therefore she was most likely not subject to income tax in this situation. Generally speaking, this is true of most things that you inherit.
Step-up in basis
In her mother’s case, most of the money she left behind in investments was subject to the step-up in basis rule. For instance, if her mom owned a stock that she bought at $5 and it grew to be worth $100 at her death, her daughter will inherit that stock at $100 and her cost basis would now be $100. That means if her daughter sold the stock at $100, instead of paying taxes on the $95 in growth that her mom would have paid, she would pay nothing in tax. Also, any growth from that point forward would not be income tax but long-term capital gains.
Where income taxes show up
One major exception to this are assets in retirement plans like Traditional 401(k)’s and IRAs. They are taxable at the income tax rate of the person who inherits the asset. This means if someone inherits an IRA, when the beneficiary withdraws money from the IRA, those dollars are taxable as income to the person who made the withdrawal. In this case you have multiple options on how to distribute the assets in order to control your taxation.
What about the ‘death tax?’
Federal estate taxes, sometimes called death taxes, are generally not a concern until the person who passed away has a net worth that exceeds a certain threshold. For 2019 that threshold is $11,400,000 per person. (Spouses receive an unlimited exemption, which means no estate taxes if the money is going to your surviving husband or wife).
This estate and gift tax exemption excludes most Americans from having to pay Uncle Sam for money they are passing along to heirs upon their death.
It is good to remain aware of the estate tax exclusion number because once an estate exceeds it, the tax rate is usually significantly higher than regular income tax rates. The exclusion is pretty high now, but it’s something that Congress likes to mess around with occasionally. As recently as 2001, the threshold was $675,000 and it affected a much larger percentage of Americans. When tax bills are passed, that number tends to move up or down depending on the political climate.
Not just federal
While the clear majority will avoid federal estate taxes, there could still be estate or inheritance taxes at the state level. Many states still have estate taxes and the exemption levels may or may not be tied to the federal exemption.
That means that while there is a federal exemption of $11.4 million, your state exemption may be $1 million. In addition, some states impose an inheritance tax, which you as an heir would have to pay. Like the federal estate tax, state transfer taxes are a moving target with several states rescinding their estate taxes in recent years to become more tax-friendly to retirees.
Talk to an expert
If you are dealing with the death of a loved one and you’re not sure about all of this, consulting with an accountant or estate planning attorney can be very valuable. If you are unsure where to find a professional, contact your employer’s financial wellness benefit or EAP and they can often help you find the right person to advise you.