Tax Implications of Receiving an Inheritance

If you received an inheritance this year, you won't want to miss this episode. Laurence Hale, AAMS®, CRPS® shares tips and insights on how to pay less taxes on the inheritance, so you can make the most of the financial gift you've been given. 

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Transcript

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Yeah, a lot of people are not really clear on the difference between the two, or that there even are two different types of taxes when there are inheritances. This is a crucial distinction that many people don't fully understand. So, estate taxes are levied on the overall estate of the deceased person before assets are distributed to heirs. So, think it's the estate is paying these taxes, and there's a federal estate tax. And as of 2024, 12 states plus the District of Columbia also have their own estate taxes. And this includes our home state of Connecticut, as well as neighboring states, Rhode island and Massachusetts. So, what are inheritance taxes? How do they differ? So, inheritance taxes are quite different. They're paid by the person inheriting the assets, not the estate itself. So if you're receiving the assets and you're in a location that has an inheritance tax, you may be paying taxes. Theres no federal inheritance tax, but six states currently impose inheritance taxes. They're Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, although Iowa is set to eliminate their inheritance tax in 2025. All right, so we don't have inheritance tax here in Connecticut or in our neighboring states, but we do have estate taxes, and the estate tax is paid by the estate, while inheritance tax is paid by the heir. Are there any other key differences? Yes, there are. And I think estate taxes are based on where the deceased lived. So they think if you're in Connecticut, and Connecticut has a very high estate tax limit and, you know, you may be okay. While inheritance taxes are based on where the assets are inherited, and this may be very important for some folks who live in Connecticut but have heirs living in some of these states that have an inheritance tax. Also, the rates and exemptions for inheritance taxes can be based on the beneficiaries relationship to the deceased. The good thing is spouses are always exempt and close relatives often. Pay lower rates or maybe exempt entirely. And that's on the. On the inheritance tax side. Got it. So your location and the location of the person leaving the inheritance both matter. What about the amount that you inherit tax free? Is there a limit on that? There is. Not too many people hit it. As of 2024, you can inherit up to 13.6 million from an estate without owing federal estate taxes. And that's actually the same limit for the state of Connecticut. But this exemption amount may vary based on your relationship to the deceased. Spouses have additional options. They may be able to add any of their deceased spouse's unused exemptions to their own by filing an estate tax return. And what about deductions? Is there a way to lower the tax bill on an inheritance? Absolutely. So beneficiaries can take deductions for things like funeral expenses, debts, and mortgages owed by the person who passed away, charitable gifts made during their lifetime, and bequests to surviving spouses. And the IRS form 706 has all the details on what can be deducted. Lawrence, once you inherit assets, and they hopefully appreciate in value over time, are there other taxes to worry about? Lawrence there are, and that's capital gains taxes. So if you've inherited assets like stocks or real estate for more than their value when you inherited them, you may owe taxes on the profits, and that rate depends on your income and how long you held the assets before selling. So that's another thing to plan for. But let me talk a little bit more about capital gains taxes if you're inheriting, and one good thing, if you have inherited assets, there is a step up in cost basis as of the date of the death of the decedent. So let me give you an example. Let's say you own an S&P 500 index investment that's worth$100,000 in a taxable account. So, meaning a non retirement account, and you only paid $10,000 for that if you pass away and leave that, let's say, to your children, that step up in cost basis now gives them the cost basis of that $100,000 when you pass away, meaning that's sort of their starting place to have to worry about capital gains taxes. So that's a good benefit to beneficiaries. However, there are other taxes to think about and that particularly comes when you look at retirement accounts, such as IRA's, 401K plans, those types of things. Those assets haven't been taxed before. And for beneficiaries who start taking money out of those types of accounts. That's when taxes will be due for those beneficiaries. So a little bit of a complex thing, and there's more to it than that. But just to make sure that people understand that there are other tax considerations when you inherit assets that you need to be aware of and plan for. Is the capital gap tax easy to- capital gains tax easy to compute? There may be people who've heard about it, but they never had to deal with it. And then maybe some kind of estate or inheritance situation comes up and now they've got to do that. Who does that? How do you find the information of the base and how the capital gains tax is computed? Sure. So capital gains taxes generally for most people are taxed at a more favorable tax rate than their ordinary income tax rate. It depends on the amount of income you receive. Totally to determine your capital gains tax rate and maximum capital gains rate is 20%. So for many people, particularly those in high incomes, that can be a tax rate that is much lower than their ordinary income tax rate. And I'm talking about long term capital gains rates. What does it mean by when I say long term? That means the assets have been held for at least one year. So twelve months in a day then you can claim that long term status. If you sell an asset that you have owned for less than a year then you have to pay short term capital gains taxes. And those tax rates are at your ordinary income tax rate. So it's definitely, from a tax standpoint for most people in most situations, much better to have a long term gain than a short term gain. As far as how to calculate it, our recommendation would be find a great accountant and have them help you. Because particularly if you're a beneficiary inheriting assets, there are some complexities that you want to make sure you factor in. Where do you get that basis? Well, you know, depending on the assets, if you inherit them, the inventory for the assets received is typically filed on what that, that form I mentioned earlier, that 706 and that will have a date of death valuation for the assets that are inherited. So that's your new cost basis. If you were to sell an asset. That's different If you were gifted an asset. So let's say a person gives somebody an asset during their lifetime, the cost basis. The person who gifted the asset goes with the asset. So if you have a security or some asset that's appreciated significantly and let's say you gift it to a child guess what they're going to be inheriting or taking on your cost basis. So they may be exposed to a higher capital gain than you, than otherwise, if you gifted an asset that hadn't appreciated or gifted cash, however they do get the date you purchased the security as well which will hopefully put them in a long term basis if owned for over a year. So a little bit complex, but there's a lot to it. And that's why we recommend working with qualified professionals and a team of advisors to make sure this all fits within your strategic financial plan. And, Lawrence, you talked about gifting money to a child. Well, let's talk about gifting money not necessarily to a child. But can it save you inheritance tax money if you, for lack of a better word, unload some of your estate in the form of gifting while you're still around? The answer is probably. So what I mean by probably, often a strategy for those who may be bumping up against that$13.6 million estate tax limit often will gift during their lifetime. And there is an annual gift exclusion of $18,000 per person per year, meaning you can gift to, and this is on the federal level, you can gift $18,000 worth of value to as many people as you want. Obviously like I said, the recipient of the gift takes on their cost basis if they were to sell an asset. But people will often have an annual gifting strategy to help reduce that which doesn't incur any taxes. However, if you are gifting more aggressively, that is essentially using your gift tax exemption, which is the same as your estate tax exemption. So you have to make sure that you're keeping track of that. You likely would have to file a gift tax return. Again, working with a qualified financial accountant is critical. And there can be a strategy in there of gifting assets that you think will appreciate. So if you gifted an asset today that you felt over the next ten years, you're young and healthy and you're doing this in advance of any real major estate planning but you think that asset will grow significantly before you pass away. Well, all that growth that you've now occurred out since you gifted the asset happens outside your estate. So there's a little bit of complexity to this. And definitely working with qualified professionals, like I said can help develop the right strategy to make sure that your goals are taken into account, your needs, income taxes and so forth. Because it can be a complex situation and making sure you're making the right choices and right decisions. And this ever changing landscape of tax law and the different regulations is key. Lawrence, you mentioned the $18,000 federal limit. What's the Connecticut limit? The Connecticut limit is the same. So thankfully you're safe in the state of Connecticut. And I'm nothing currently aware of any states that impose a gift tax on the annual gift exclusion. I may be mistaken in that. However that is a fairly common thing for folks to do help, particularly children while they're alive. A lot of folks who maybe in their elder years are thinking, how can I help my kids now? They might want to buy a house or have needs or fund grandchild's education or something like that. And that often will be ways that grandparents can help, or parents can help kids without worrying about gift tax or obviously, inheritance tax consequences. Is there a limit to how much you can legally gift to a person, adult or child, without having to report it? It's the 18,000 is basically what you have if you are over 18,000, again, per person per year. So if you have a couple that's gifting you could do 18,000 each. So 18 from each spouse. So that's a total of $36,000 per person per year in a married situation, 18 if it's just one individual. You don't have to report that. However, as soon as you gift in excess of that, you do need to file a gift tax return. Again, potentially no taxes owed. However, that goes in essentially an ongoing ledger with the IRS where they're keeping track of how much did you gift in excess of your annual gift exclusion versus how much do you have in your estate when you ultimately pass away. A lot of complexities to navigate. Lawrence, what's your advice for people who receive an inheritance and want to handle it as smoothly as possible? I can't stress this enough. It's really to consult with experienced professionals. That team typically includes an estate attorney, a tax advisor, and a financial planner, a wealth manager. And at our firm, we guide clients through the estate planning process and process of preparing to receive an inheritance. So we work with, you know, oftentimes folks who may pass away, and we're working with their you know, their executors. And we also work a lot with the recipients of the inheritance. So our goal really is to help them retain and grow as much generational wealth as possible while minimizing taxes and stress. And in fact, we have a step, a free step by step guide on this topic that listeners can download from our homepage at our website, whzwealth.com so feel free to go there. Take a look at that. It has a lot of useful tips. And this is not planning that you want to do last minute. Estate planning is something you want to really be thinking about particularly as you enter the workforce, as your family grows. There are some really important things that you need to do at various stages of your life. A lot of what we're talking about is when someone actually passes away, a lot needs to go into it to have a solid estate plan aligned to your goals and any legacy wishes. That's a great resource. Lawrence, can you share a client story that illustrates how you help people in this situation? Sure. We had a client named Michael, whose uncle left a fairly complex estate to he and his brothers. And they came to us to help figure out the best way to handle the inheritance. And Michael said we were amazed at how it. Organized, courteous and communicative. WHZ was the moment I walked in there and met with them. I was very comfortable and knew it was going to be a good experience. So we broke everything down for all of them and helped them navigate the process smoothly. And now Michael is actually a retirement planning client of ours as well. And you can read more about his story on the website. And I want to expand a little bit on the kinds of things that we did to help manage what was a complex situation. And this is something for those who are planning for their estate should really pay heed to, is depending on throughout people's lives, they've often accumulated a lot of different types of assets, different types of accounts. Think 401K's, IRA's, could be accounts at banks like CD's, savings accounts. They could have an old pension or an annuity that they had you know, almost forgotten about. They may even have stock certificates or stock in what's called book entry form. They could have life insurance policies and so forth. And oftentimes throughout people's lives, they've done a great job saving, accumulating these assets. But really making sure that you understand, does it need to be in all these little pieces and consolidating and making sense of these so that there's a comprehensive and complete plan that brings all of these things together, keeps track of them, understands not just where they are, but what they are. And are they invested appropriately based on the client's needs? It is something that's important to do, particularly if you have a complex situation. So there are often times we work with clients that have brought in literally tens of different statements. They've got stock from a company they used to work for and many other assets. And it can be complex and a little overbearing to have to deal with all these companies to try to consolidate. And that's one thing we really take our time and explain and help clients consolidate these assets, make sense of them, and then deploy them in a way that is aligned to their financial plan and their goals, to make sure that they're making the most out of the assets that they've worked hard to accumulate. And maybe as we wrap things up, just a couple of thoughts in general about it being a good idea for people to get their estate stuff, their paperwork in order, because you never know what will happen tomorrow. And the, the better you organize, the more easy it's going to be to navigate this situation when necessary. Absolutely. Some people often will leave in our safe deposit box or that one drawer that everyone has that has the important documents in their house, something that some people refer to as a family love letter. And what that is is it's essentially a roadmap of. Who do I call? Who do I need to reach out to if my parent or spouse passes away? Things like that advisory team, that estate attorney, the insurance agent, the accountant, the financial advisor or wealth manager. Where do you have accounts what other assets may you have or what other complex things so that it really leaves a roadmap for those that are important to you to help them navigate this. And if you've done a lot of that work and organization and work with that core team of advisors to help you build that estate plan and that cohesive strategy, it often can save your heirs a lot of heartache and headaches as well as maximize and take advantage of all the opportunities that exist within estate planning strategies. There's a lot to it. You were obviously just touching on the service of a number of parts of this topic, but it's really, really key to make sure that you're taking good care just as you do when you're living that you leave things in good shape for your beneficiaries. For more information regarding wealth management and customized financial planning with Weiss, Hale & Zahansky Strategic Wealth Advisors, please visit whzwealth.com Weiss, Hale & Zahansky Strategic Wealth Advisors offer securities and advisory services through Commonwealth Financial network member FINRA SIPC, a Registered investment advisor, fixed insurance products and services offered through CES Insurance agency. They practice at 697 Pomfret Street Pomfret Center, Connecticut 06259 392-A Merrow Road, Tallinn, Connecticut 06084 They can be reached at 860-928-2341 Weiss, Hale & Zahansky Strategic Wealth Advisors do not provide legal or tax advice. The tenured financial services team strives to support clients in achieving their financial life goals while providing absolute confidence and unwavering partnership for life.