Many people have concerns about the taxes that can enter the picture when an estate is being administered. The good news is that the laws are actually quite favorable. You do not have to report an inheritance that you receive through the terms of a Will, and life insurance policy proceeds fall into this category as well.
We looked at the stepped-up basis in a recent post, but in case you missed that entry, an inheritor is not responsible for capital gains that accumulated during the life of the decedent.
The basis would be reset at the time of acquisition, and the inheritor would only be on the hook for future gains.
Why are inheritances considered to be tax-free income? To explain through the utilization of a simple example, let’s say that you save five percent of your net pay for many years. You live within your means, and you develop a nest egg to draw from during retirement.
As it turns out, you never need the money, and you are going to leave the savings account to your only child. You paid taxes before you deposited the money into the account. The inheritance that your child will receive is a remainder that was left over after you paid taxes.
If the inheritance was taxable, it would be an instance of double taxation, and this would not be fair. This makes all the sense in the world, but it goes out the window if your savings are particularly robust.
Federal Estate Tax
We have a federal estate tax in the United States that packs a wallop with a 40 percent maximum rate. You do not have to pay the tax unless the value of your estate exceeds the credit or exclusion.
In 2017, the exclusion was $5.49 million, and in December of that year, the Tax Cuts and Jobs Act was enacted. This measure increased the exclusion to $11.18 million in 2018, and this figure adjusted for inflation has been in place since then.
For the rest of 2021, the exclusion will be $11.7 million. We should point out the fact that the relevant provision in the Tax Cuts and Jobs Act will expire at the end of 2025.
If there are no changes between now and then, the exclusion will go back to $5.49 million adjusted for inflation in 2026. Since the Democrats are holding control in Washington, there is a good chance that the exclusion will be reduced before then.
You can transfer any amount of property to your spouse tax-free, because there is an unlimited spousal deduction. The one caveat to this statement would be the stipulation that this marital deduction is only allotted to American citizens.
Since 2011, the estate tax exclusion has been portable between spouses. In tax parlance, the word “portability” refers to the ability of the surviving spouse to use the exclusion that was allotted to their deceased spouse.
2021 Gift Tax Exclusion
A gift tax has been in place since 1932 to stop people from giving gifts while they are living to avoid the estate tax. It was unified with the estate tax during the 1970s, so the $11.7 million exclusion that we looked at is a unified exclusion that applies to lifetime gifts and your estate.
However, there is a separate annual per person gift tax exclusion that can be used to gift a certain amount to an unlimited number of recipients in a given year in a tax-free manner.
There can be adjustments when a new year rolls around to account for the cost of living, and many people were wondering if there would be an increase in 2021. In fact, the exclusion will remain the same. It was $15,000 last year, and this is the amount that will be in place this year.
In addition to this annual exclusion, there are two other ways you can give tax-free gifts. You can pay medical bills for others without being taxed for your generosity, and you can also cover school tuition for other people.
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The ideal way to proceed will depend upon the circumstances, so personalized attention is key. This is exactly what you will receive when you choose our firm.
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