In our estate planning practice, we commonly have clients ask “Will I be taxed if I receive an inheritance from a loved one?” In order to answer this question, there are a couple of things that will help you understand how taxes come into play when someone dies and leaves assets to designated beneficiaries.
First, let’s identify what taxes we are talking about. When it comes to inherited assets, there are three main types of taxes to consider, i.e. estate tax, inheritance tax, and income tax. The terms “estate tax” and “inheritance tax” are often used interchangeably but there is a difference. The key to these taxes is who is responsible to pay them. An estate tax is a tax imposed on the gross estate assets and the tax is paid at the estate level before going to the beneficiaries. An inheritance tax is a tax imposed on specific assets received by a beneficiary and the tax is usually paid by the beneficiary, not the estate. Florida residents are fortunate in that Florida does not impose an estate tax or an inheritance tax.
The Federal government imposes an estate tax which begins at a whopping 40%–this would wipe out much of the inheritance! Fortunately, there is an exemption called the “Unified Credit” which lessens the blow for most estates. In simple terms, the Unified Credit works in such a way that an estate must exceed a certain dollar amount before the estate is subject to Federal estate taxation. At the time of this writing in 2020, based on the Unified Credit each U.S. citizen could die with an estate up to $11,580,000 and there would be no Federal estate tax due. For married couples, that amount is doubled since each spouse is entitled to the exemption and each spouse’s exemption is portable to the last spouse to die.
While Florida imposes neither an estate tax nor an inheritance tax, you must be careful because some states do have estate taxes and some have inheritance taxes. For example, New York and Illinois impose their own estate taxes and Pennsylvania and New Jersey impose inheritance taxes. Maryland imposes both. If the deceased person owned assets in those states (and a few others), there could be a tax issue at least as to assets within those states.
Another tax consideration on inherited assets is income tax. Most assets received by devise through a Will or Trust do not cause an income tax liability. So if you receive a distribution of cash from a deceased loved one’s estate, in most instances you will not pay income taxes on that distribution. However, some types of inherited assets, such as a traditional IRA or 401K, can result in an income tax being owed by the named beneficiary. The liability occurs when the beneficiary takes the funds out of the IRA or 401K. An easy way to understand this is that with a traditional IRA or 401K, the owner would pay income tax on the funds as they are withdrawn. If the owner would have to pay income tax when taking money out, then a beneficiary is essentially in the same boat.
Another asset which is often paid out at the time of death is life insurance benefits. Fortunately, the benefits are not considered income subject to being taxed. However, it should be noted that when determining the gross estate for estate tax purposes as discussed above, life insurance death benefits are included unless they have been placed into an irrevocable life insurance trust (sometimes referred to as an “ILIT”).
An example might help demonstrate these basic rules. Mark owns assets in his Trust totaling $3,500,000. These are comprised of a house valued at $500,000 and $3,000,000 is a money market account. He also has $600,000 held in an IRA and life insurance on his life with a death benefit of $1,000,000. Mark’s Trust, his IRA, and his life insurance all name his only daughter, Cindy, as sole beneficiary. Mark dies suddenly as a result of COVID-19. He is a Florida resident and all of his assets are in Florida. When Cindy learns what Mark has left her, she is concerned about taxes.
In this example:
Will there be any state or Federal estate tax due? No, Mark’s total assets are below the Unified Credit amount of $11,580,000 so no Federal estate tax is due and Florida does not impose its own estate tax.
Will there be any state or Federal inheritance tax due? No, neither Florida nor the Federal government impose an inheritance tax.
Will there be any income tax due on the assets in the Trust? No, the home and the money market account will pass to Cindy without being subject to income tax.
Will there be any income tax due on the IRA? Yes, but only as the money is withdrawn. In this instance, the IRA could be rolled-over by Cindy into an inherited IRA and she would not be required to immediately withdraw all of the funds. This can delay—but not avoid—when the income tax becomes due. When named as beneficiary of an IRA, the beneficiary should consult a financial adviser before taking any action on the IRA.
Please note: In our estate administration and probate practice, when a person dies and beneficiaries are inheriting assets, we always encourage that they confer with their CPA and their financial advisor in order to make the final determination on whether a tax return must be filed and whether taxes are owed.