Many people are surprised to hear that taxation is usually not much of a problem when an estate is being distributed to the heirs. There are no income taxes on inheritances, and if you inherit appreciated assets, you get a step up in basis. This means that you would not have to pay capital gains tax on gains that accumulated during the life of the decedent.
A tax that can take a heavy toll if you are exposed is the federal estate tax. It carries a whopping 40 percent maximum rate, but you probably do not have to pay it, because there is a credit or exclusion that is rather high. At the time of this writing in 2020, the exclusion stands at $11.58 million.
There is an unlimited marital deduction that allows for tax-free transfers between spouses, but transfers to anyone else are potentially taxable. You cannot give large gifts to get around the estate tax, because there is a gift tax that is unified with the estate tax.
To explain through the use of a simple example, if you gave away $5.58 million in taxable gifts today and you passed away later this year, there would only be a $6 million credit left to apply to your estate.
It should also be noted that the estate tax is portable between spouses that are American citizens. This means that if you predecease your spouse, they would be able to use your exclusion.
Connecticut State Estate Tax
Most states do not have state-level estate taxes, but there are some that do, and this is especially common on the east coast.
Here in Connecticut we do have a state estate tax, and the exclusion is much lower than the federal exclusion. As a result, you could be exposed to this tax even if you do not have to be concerned about the federal tax.
During the current calendar year, the Connecticut state estate tax exclusion is $5.1 million. The rate is a graduated rate that starts at 7.2 percent, and it tops out at 12 percent.
It is natural to assume that the term “inheritance tax” is just another way of referring to the estate tax. In fact, these are actually two different forms of taxation. As we have explained, an estate tax is applied on the entire taxable portion of an estate before it is transferred to the heirs.
An inheritance tax can potentially be imposed on transfers to each individual person that is receiving an inheritance when one estate is being administered. Fortunately, there is no federal inheritance tax, and there are just six states in the union that have one.
Connecticut is not one of the six, so this is one form of taxation we usually do not have to be concerned about.
We used the qualifier “usually” because you could be forced to pay an inheritance tax if you inherit money from someone that lived in a state with an inheritance tax. For your information, the states are Pennsylvania, Maryland, Nebraska, New Jersey, Iowa, and Kentucky.
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