3/22/2012 2:00 PM ET|
Could taxes take your inheritance?
One wrong move could mean that the IRS takes a bigger bite out of the money your departed friend or family member left to you.
Losing a person in your life is difficult enough without having to figure out how to hold on to what the dearly departed left you.
The tax season brings more worries for those who've lost a friend or loved one and have received an inheritance. That last gift from Mom, Dad, the grandparents or anyone else in your circle can be a touching gift, but heirs might unknowingly incur some serious tax penalties.
Estate tax and inheritance tax laws written in Washington and state capitals can take a big bite of what's left behind, but they don't have to.
"Don't feel like you need to be in a rush to make an investment decision after a person passes away," says Chris Hobart, the CEO and founder of Hobart Financial Group in North Carolina. "You're in a rush and don't know all the rules, then all of a sudden you realize you owe taxes on all this money after you've bought a car or bought a pool."
The process of claiming an inheritance is a tangle of qualified and nonqualified money, state and federal taxes, estate and inheritance taxes and the thresholds and loopholes for each. An unknowing or unwitting heir who has come into some money suddenly has to cope not only with the loss, but also with a series of inheritance and estate laws that Jonathan Bergman, vice president of Palisades Hudson Financial Group in Scarsdale, N.Y., calls "a minefield."
With the tax-filing deadline fast approaching, Hobart and Bergman offer the following advice to heirs struggling to figure out how much, if anything, they owe the state or Internal Revenue Service before settling their affairs:
1. Take inventory
When President Barack Obama and Congress passed the Tax Relief Act of 2010, it not only extended the Bush tax cuts but implemented a federal estate tax that bumped up the exclusion from $1 million to $5.1 million while dialing down the tax rate on funds beyond that threshold to 35% from 45%.
Heirs who think they're under that $5.1 million mark based on their best guess of what the combination of the estate's cash and property is worth really should hold off on earmarking that cash for the beach house or kids' college fund. Nothing's certain until the formal appraisal takes place.
"When you inherit something, generally the cost basis of the security is equivalent to the fair-market value on the date of death," Bergman says. "In certain instances, there may be an alternate valuation date six months after the date of death, but that would be determined by the personal representative of the decedent."
Even those assets may not be the whole picture. Hobart warns that life insurance policies the heirs aren't aware of can still bump them over the limit.
"People think life insurance is tax-free and that's great, but if the life insurance pays into the estate and not into an irrevocable life insurance trust, that counts toward the $5.12 million threshold," Hobart says. "Let's say that Mom and Dad had $1 million in assets, but they went crazy and got a $9 million life insurance policy; that estate is now worth $10 million and falls under federal estate-tax exemption."
Staying under the $5.1 million threshold doesn't necessarily ward off the estate tax, either. Uncle Sam may not get out of bed for less than $5.1 million, but 16 states and the District of Columbia certainly do. Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Ohio, Oregon, Rhode Island, Tennessee, Vermont and Washington all impose state estate taxes of up to 35% for those worth more than a specified amount. That ceiling is as high as the fed-matching $5.1 million in North Carolina, but dips as low as $675,000 in New Jersey or $338,333 in Ohio.
That's just what gets taxed well before filing time. If an heir happens to live in Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey or Pennsylvania, there's an extra inheritance tax tacked on once the inheritance makes it into his or her hands. Spouses of heirs are exempt from all of these taxes, as are life insurance payouts, but that's about as kind as each of these plans gets. Descendants in Indiana, Nebraska and Pennsylvania are taxed anywhere from 1% to 20% after coming into money or property. Domestic partners in all 16 states excluding New Jersey are on the hook for inheritance taxes at those rates as well.
"I would love to tell you that it had any sort of rhyme or reason from state to state or that it made any kind of sense," Hobart says.
Even if you manage to escape all those taxes, your inherited real estate and property can be a tax waiting to happen. Bergman notes that when those items are finally sold, they're subject to long-term capital gains treatment even if you've had them for less than a year. On the federal level, that amounts to 15% of the difference between the selling price and the new cost basis.
2. Check for qualified money
All of the previously mentioned taxes apply solely to the cash, real estate and other property that's considered nonqualified money. If the person who passed away had any tax-deferred accounts or funds and named you as a beneficiary, the IRS is going to want a moment of your time.
"With qualified money -- money from 401k's, IRAs, 403b's -- it's money that's never been taxed before and, because of that, people inheriting that type of money need to be very careful," Hobart says. "If they do inherit that as a lump sum and cash that out by putting it all into a bank account, that is fully taxable as ordinary income. It doesn't matter if it's $1 or $20 million, it's a taxable asset."
Much like withdrawing from your own 401k or individual retirement account early, taking money out of similar accounts left by Mom or Dad has consequences. While spouses are immune to such levies in certain cases, a descendant making $40,000 a year and hanging out in the 25% tax bracket can get bumped up to the 35% tier in a hurry if he or she withdraws $1 million from the folks' IRA. A much smaller sum, however, may cost more to keep in the account than it will on the forms come tax time.
"If it's a small dollar amount, it probably makes more sense to take it as a lump sum to reduce the administrative burden," Bergman says. "You're still going to have to pay income tax on it during the tax year."
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