inheritance tax

What It Is

An inheritance tax, also called an estate tax, is a tax assessed on all or a portion of an inherited estate. Life insurance, pensions, real estate, cars, belongings and debts are all part of one's estate. "Death tax" is generally a pejorative term for this concept.

How It Works

Inheritance tax rates vary, and only the portion of an estate value above a certain threshold is taxed at rates as high as 50%. These "thresholds" often change yearly. Many states used to receive a portion of the estate taxes recovered by the federal government, but now many states levy their own estate taxes instead. Each state sets its own estate tax rates and exclusions.

Inheritance taxes usually apply to assets inherited by heirs, but they usually don't apply to assets inherited by spouses. Inheritance taxes on small businesses and farms left to heirs also face unique estate tax treatment.

Step-ups, which refer to an increase in the price at which an investment was purchased, reduce tax bills because the IRS essentially pretends the original cost of an asset is the market value when you inherit the assets. Thus, heirs can sell those investments immediately and might pay little or no income tax.

Why It Matters

Inheritance taxes are not the same as probate fees, which can also cost thousands of dollars. Settling an estate may also involve executor fees, court fees, recording fees and attorney fees. In many cases, inheritance taxes and fees must be paid as the estate is probated, meaning that the heirs will need to come up with the money just about immediately after a person's death. In many cases, the heirs either have to sell the assets they've inherited just to pay the taxes and fees or they have to borrow money to do so. Part of estate planning, therefore, is preparing for the taxes due upon one's death, and where one lives can have a significant impact on the amount of estate tax his or her heirs pay.

Many people attempt to reduce the size of their estate while they're still alive by giving away portions of their estate. This can be done without triggering estate taxes as long as the gifts are below the gift-tax exemption limit. Establishing a trust often reduces estate taxes because it allows a person to transfer legal title of his or her property to another person while he or she is still alive. It also gives the trustee (the person acting on behalf of the deceased person, sometimes called the decedent) the authority to distribute assets immediately to the beneficiaries based on the terms of the trust. No court is involved, so there are no probate fees and no public record of the value of the estate. Many financial advisors urge clients to have trusts, especially those who live in states where probate fees are especially high or if the client owns a home or real estate. Trusts are not for everyone, however, so it is important to seek proper financial advice.

Source: Investing Answers