One of the most common concerns among parents planning their estate is whether their children will have to pay taxes on their inheritance. While inheritances are generally not considered taxable income, estate taxes, inheritance taxes, and capital gains taxes can still impact the assets passed down. Understanding how these taxes work and employing strategic estate planning can help minimize or even eliminate the tax burden on your heirs.
If you're looking for ways to protect your children's inheritance from excessive taxation, consulting with an experienced estate planning attorney is crucial. Contact us by either using our online form or calling 414-253-8500 for personalized guidance.
Understanding Estate Taxes vs. Inheritance Taxes
Estate Taxes
Estate taxes are imposed on the total value of a deceased person's estate before the assets are distributed to heirs. The federal government and some states levy estate taxes, but they only apply if the estate exceeds a certain exemption amount.
- Federal Estate Tax: The IRS imposes an estate tax on estates valued above a specific threshold (which is $13.61 million per individual in 2024). Any amount over this exemption is taxed at rates up to 40%.
- State Estate Taxes: Some states impose their own estate taxes with much lower exemption thresholds, meaning estates that don't trigger federal taxes might still be taxed at the state level.
Inheritance Taxes
Unlike estate taxes, inheritance taxes are imposed on the recipients of an inheritance, not the estate itself. The key points about inheritance taxes include:
- There is no federal inheritance tax.
- Only six states currently impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
- The tax rate and exemption depend on the relationship between the decedent and the heir-spouses and direct descendants often receive favorable treatment.
If you live in a state with inheritance taxes, your children may have to pay a percentage of their inherited assets, depending on local laws.
Are Inherited Assets Taxable?
While the inheritance itself is generally not taxable income, specific types of inherited assets may trigger taxes when sold or distributed:
- Cash Inheritances: Not subject to income tax.
- Retirement Accounts (401(k)s, IRAs): Heirs may owe income tax on distributions from inherited retirement accounts.
- Investments (Stocks, Bonds, Real Estate): Capital gains taxes may apply if the assets are sold for more than their stepped-up basis.
- Life Insurance Proceeds: Generally tax-free unless the policy was part of a taxable estate.
Understanding how these taxes work is crucial in ensuring your children maximize their inheritance.
The Step-Up in Basis Rule
A major tax advantage for inherited assets is the step-up in basis rule. When a beneficiary inherits an asset, its tax basis is adjusted to its fair market value at the time of the owner's death.
- Example: If your parent bought a home for $200,000, and its value increased to $500,000 by the time of their passing, the new basis for the heirs is $500,000. If they sell it at $510,000, they only pay capital gains tax on the $10,000 increase.
This rule significantly reduces capital gains taxes when inherited assets are sold.
How to Minimize or Avoid Taxes on Your Children's Inheritance
Proper estate planning can significantly reduce or eliminate the taxes your children may have to pay on their inheritance. Here are some strategies to consider:
1. Gifting Assets During Your Lifetime
One way to reduce estate taxes is to give away assets while you're still alive. The IRS allows individuals to gift up to $18,000 per recipient per year (as of 2024) without triggering gift taxes. Married couples can combine their exemptions to gift $36,000 per recipient annually.
- Example: If you have three children, you and your spouse can gift them a combined total of $108,000 per year tax-free.
- Gifting assets before death reduces the overall size of your taxable estate, potentially keeping it below the federal estate tax exemption.
2. Using Trusts to Shield Inheritance from Taxes
Trusts offer several advantages for estate planning, including tax benefits and asset protection. Consider these trust options:
- Revocable Living Trusts (Learn more): Helps avoid probate but does not provide estate tax protection.
- Irrevocable Trusts (Learn more): Transfers assets out of your estate, potentially reducing estate taxes.
- Charitable Trusts (Learn more): Can reduce estate taxes while supporting a cause.
- Medicaid Asset Protection Trusts (Learn more): Helps protect assets from Medicaid's long-term care spend-down rules.
Placing assets in a properly structured trust can ensure that your children receive their inheritance with minimal tax liability.
3. Naming Beneficiaries Wisely
Certain assets, such as retirement accounts and life insurance policies, pass directly to designated beneficiaries, bypassing probate. However, tax implications vary:
- Retirement Accounts (401(k)s, IRAs): Naming a spouse as the beneficiary allows for tax-free rollovers, while non-spouse beneficiaries may be required to withdraw all funds within 10 years, triggering income tax.
- Life Insurance: Generally not subject to income tax, but if the estate is the policy owner, the proceeds may be included in the taxable estate. Setting up an Irrevocable Life Insurance Trust (ILIT) can help avoid estate taxes.
4. Converting Traditional IRAs to Roth IRAs
Inherited traditional IRAs require beneficiaries to take distributions, which are taxed as income. However, converting to a Roth IRA during your lifetime allows you to pay taxes upfront at today's rates, and your children can withdraw the funds tax-free in the future.
- Key Benefit: Roth IRAs do not have required minimum distributions (RMDs) for the original owner, allowing assets to grow tax-free for longer.
5. Utilizing the Marital Deduction and Portability
For married couples, the unlimited marital deduction allows spouses to pass assets tax-free to each other. Additionally, portability allows a surviving spouse to use their deceased spouse's unused federal estate tax exemption, potentially doubling the amount that can be passed tax-free to heirs.
- Example: If one spouse dies in 2024 without using their $13.61 million exemption, the surviving spouse can transfer up to $27.22 million tax-free.
State-Specific Tax Considerations
Since estate and inheritance taxes vary by state, it's important to understand the specific laws in your state of residence. Some states impose their own estate tax with lower exemption thresholds, while others have no estate or inheritance tax at all. If minimizing taxes is a priority, relocating to a tax-friendly state may be an option.
Key Takeaways for Protecting Your Children's Inheritance
- Federal estate tax only applies to estates exceeding $13.61 million (2024).
- Only six states impose an inheritance tax; spouses and direct descendants often receive exemptions or lower rates.
- Gifting strategies, trusts, and proper beneficiary designations can significantly reduce or eliminate taxes.
- Step-up in basis rules help minimize capital gains taxes for inherited assets.
- Converting retirement accounts to Roth IRAs can prevent income tax burdens on your children.
Contact an Estate Planning Attorney to Secure Your Family's Future
Ensuring your children receive their inheritance with minimal tax burden requires strategic planning. An experienced estate planning attorney can help you explore trusts, gifting strategies, and tax-efficient wealth transfer options tailored to your needs.
Protect your children's inheritance today-schedule a consultation with Heritage Law Office by contacting us online or calling 414-253-8500.
Frequently Asked Questions (FAQs)
1. Do children have to pay federal taxes on inherited money?
No, inherited money is not considered taxable income under federal law. However, if the inheritance includes assets like retirement accounts or investments, taxes may apply when those assets are sold or withdrawn.
2. What is the difference between estate tax and inheritance tax?
- Estate tax is applied to the total value of the deceased person's estate before assets are distributed to heirs. The estate pays this tax.
- Inheritance tax is imposed on the beneficiaries receiving the inheritance and varies by state.
3. How can I avoid estate taxes for my heirs?
To reduce or eliminate estate taxes, consider:
- Gifting assets during your lifetime.
- Establishing trusts such as irrevocable trusts or charitable trusts.
- Maximizing estate tax exemptions through marital deductions and portability.
- Converting traditional IRAs to Roth IRAs for tax-free withdrawals.
4. Do beneficiaries pay capital gains tax on inherited property?
Not immediately. Thanks to the step-up in basis rule, the tax basis of inherited property is adjusted to its fair market value at the time of the original owner's death. Beneficiaries only owe capital gains tax if they sell the property for more than the stepped-up value.
5. Can life insurance proceeds be taxed as part of an inheritance?
Life insurance payouts are generally not subject to income tax, but if the deceased owned the policy, the proceeds may be included in the taxable estate. An Irrevocable Life Insurance Trust (ILIT) can help exclude life insurance from estate taxes.