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Retirement

Final Answer: Three Estate-Planning Tax Considerations

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January 11, 2017
Planning your inheritance and estate management tips.

No one likes to think about a serious illness or death, but developing an estate plan can be a loving way to take care of your family after you are gone. The basic components of an estate plan could include a will, a living trust, and power of attorney. But the first step is to create a plan.

Look at it this way—if you don't have an estate plan, the authorities will make one for you after the fact, and the result could be far from what you intended. U.S. laws vary from state to state, with different amounts directed to spouses and children, depending on where you live.

There are a number of tax considerations to take into account when you develop your estate plan. Here are three things to consider in your estate planning. As always, it’s best to consult with a tax attorney regarding your specific situation and in order to comply with changing laws.

1. The Estate Tax Vs. Inheritance Taxes—Yes, There’s a Difference

Unless your family counts among the wealthiest 2% of Americans, the estate tax probably won't affect you. The federal estate tax is essentially a transfer tax on property including cash, real estate, and stock paid by the heirs.

Basically, you will need to file an estate tax return for estates with combined gross assets exceeding the exemption limit of $5,450,000 in 2016, and $5,490,000 in 2017, according to the Internal Revenue Service. The IRS says, as of 2011, you may elect to pass on any of your unused exemption to a surviving spouse.

But don’t confuse the federal estate tax with “inheritance taxes,” which are state taxes that a person may need to pay on money or property they have inherited after the death of a loved one. "Unlike the federal estate tax, the beneficiary of the property is responsible for paying the tax, not the estate. However, as of 2016, only eight states impose an inheritance tax. And even if you live in one of those states, many beneficiaries are exempt from paying it," according to experts at TurboTax. Check with your tax attorney or accountant for details.

The main difference between an estate tax for the ultra-wealthy and an inheritance tax imposed by some states is who is required to pay it.

  • An estate tax is paid out of the deceased's assets prior to the distribution of the state.
  • The inheritance tax comes into play after the executor of the estate has divvied up and distributed the assets to the beneficiaries—and each individual beneficiary is responsible for paying the tax.

TurboTax offers this example: "A state may charge a 5% tax on all inheritances larger than $2 million. Therefore, if your friend leaves you $5 million in his will, you only pay tax on $3 million, which is $150,000," TurboTax says.

The six states that currently impose an inheritance tax include Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rates on inheritances can be as low as 1% or as high as 20% of the value of property and cash you inherit. But be sure to check with your state, as laws do change from time to time.

2. Even With Death, No Respite From the Tax Man

When someone passes, the tax man still demands a final accounting. The task of filing the taxpayer's final return falls to the executor, the administrator, or a survivor. "The return is filed on the same form that would have been used if the taxpayer were still alive, but 'deceased' is written after the taxpayer's name. The filing deadline is April 15 [April 18 in 2017] of the year following the taxpayer's death," according to TurboTax.

3. What Happens with an Inherited IRA?

Money in traditional IRAs, employer-sponsored retirement plans including 401(k)s and 403(b)s, and annuities are treated as income in respect of a decedent, and therefore taxed to the heir, TurboTax says.

There is always an exception to the rule—and in this case, it revolves around Roth IRAs and Roth 401(k)s. "No taxes are due on inherited Roth distributions as long as the account had been open at least five years at the time of the owner’s death. If the original owner dies before the five-year period has elapsed, you can satisfy the holding period by rolling the account over into an inherited Roth IRA and waiting until the holding period has passed," TurboTax says.

Your estate plan is your legacy and should be treated with care. Consider taking time now to create a plan that will distribute your assets in the manner that you intend. 

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