People are often confused about the way that inheritances can be taxed. If you have heard the terms “estate tax” and “inheritance tax,” you may assume these are two different ways of describing the same thing.
There are also those that think that the terms refer to the requirement to report inheritances as income when you file your regular tax returns.
In reality, all of the above assumptions are mistaken, and we will provide clarity in this post.
Income Taxes and Capital Gains Responsibility
A lot of folks are surprised to hear that you do not have to pay income taxes on inheritances.
Plus, if you inherit assets that appreciated during the life of the person that left you the resources, you would get a step-up in basis. This means that you would not be required to pay capital gains tax on the appreciation that accumulated during the life of the decedent.
Federal and State Estate Taxes
There is a federal estate tax, but it does not impact most families, because there is an exclusion that can be used to transfer a certain amount tax-free. In 2020, the exclusion is $11.58 million.
Each year, there are inflation adjustments, so it will be a bit higher next year. To give you an idea of the size of the increases, the exclusion was $11.4 million in 2019.
You can’t give large gifts to avoid the estate tax, because there is a gift tax that is unified with the estate tax. If you gave away $11.58 million in taxable gifts and you passed away this year, your entire estate would potentially be subject to the estate tax.
In Connecticut, we have a state-level estate tax, and it is possible to be exposed to this tax even if you are exempt from the federal tax. The state estate tax exclusion is just $5.1 million this year, and the rate is a graduated rate that starts at 7.2 percent, and it maxes out at 12 percent.
There is only one state in the United States that has a gift tax, and guess what? That state is Connecticut, and the exclusion is the same as the state level estate tax exclusion.
We should point out the fact that you don’t have to pay estate or gift taxes on transfers to your spouse. This is true on the federal level and the state level.
Inheritance Taxes
An inheritance tax is a different form of taxation. As we have stated, the entire taxable portion of an estate would be shaved down by an estate tax.
Each individual inheritor could be subject to an inheritance tax, so it can be imposed multiple times when one estate is being administered.
That’s the bad news, but the good news is that there is no federal inheritance tax, and we do not have a state-level inheritance tax in Connecticut. There are a total of six states with inheritance taxes, including New Jersey and Maryland.
If you were to inherit property that is located in a state with an inheritance tax, it could definitely be a factor for you. However, in states with inheritance taxes, close relatives like children, parents, and grandchildren are typically exempt.
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