There can be some confusion when it comes to the taxes that can be levied on inheritances. You may have heard the terms “estate tax” and “inheritance tax” utilized, and they can leave you scratching your head.
Are these two different taxes, or are the terms used interchangeably? Do they refer to income taxes on inheritances? These are good questions, and we will provide clarifications in this post.
Life insurance policy proceeds and an inheritance that you receive through the terms of a will or trust are not considered to be taxable income by the IRS or the state tax authorities. Distributions of the principal in a living trust are not taxable, but interest distributions would be subject to taxation.
If you are the beneficiary of a traditional individual retirement account, the distributions would be taxable, but Roth account beneficiaries receive distributions in a tax-free manner.
An inheritance tax is a completely different type of taxation. This tax is levied on transfers to each individual inheritor when an estate is being administered. We do not have a federal inheritance tax in the United States.
However, there are six states in the union that have state-level inheritance taxes. These states are New Jersey, Maryland, Kentucky, Iowa, Nebraska, and Pennsylvania.
The good news for people in these states is the fact that close relatives like a spouse, children, parents, and grandchildren are typically exempt.
Even though we do not have this tax in New York, if you inherit property in a state with an inheritance tax, it would be a factor. For example, let’s say that your uncle leaves you a valuable piece of property in New Jersey.
As a nephew or niece, you would be a Class D beneficiary, and you would not be exempt. The first $700,000 would be taxed at a 15 percent rate, and it would go up to 16 percent for the portion that exceeds this amount.
An estate tax is yet another form of taxation, and it is levied on the entire taxable portion of an estate before it is distributed to the heirs. There is a credit or exclusion that can be used to transfer a certain amount tax-free, and the remainder would be subject to the tax.
We have a federal estate tax with an exclusion that stands at $11.7 million in 2021. There are 12 states that have state-level estate taxes, and New York is one of them. The exclusion in New York is $5.93 million this year.
There is a federal gift tax that is unified with the estate tax, so the exclusion applies to large lifetime gifts and your estate. However, there is an additional $15,000 per person, per year gift tax exclusion.
You can give this much to any number of gift recipients in a calendar year, totaling any amount of money, free of taxation. There are additional exemptions that allow you to pay school tuition and medical bills for others tax-free.
On the state level, there is no gift tax, but there is a three year clawback provision. Large gifts that you give within three years of your passing are considered to be part of your estate for tax purposes.
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