Finance

What You Need to Know About Inheritance Tax

Dan Nicholson

Imagine receiving a letter in the mail informing you of an unexpected inheritance from a distant relative. While the prospect of receiving surprise assets may seem exciting at first, it often comes with a less exciting companion: inheritance tax. Suddenly, what seemed like a windfall becomes a complex puzzle of tax laws and potential fees. But with the right knowledge and some savvy planning, the impact of inheritance tax can be minimized, leaving more of it to spend on the important things in life. 

Who Pays Inheritance Tax?

First of all, we need to distinguish between estate tax and inheritance tax. Both taxes are calculated based on the fair market value of the deceased's property, but who pays them and when they're paid diverge significantly.

Estate tax, as defined by the IRS, is the tax on the right to transfer property when someone passes away. It covers everything they owned or had interests in at their date of death, including cash, real estate, and anything else of value. There are certain deductions allowed for debts, expenses, and bequests to spouses or charities. After all the math is done, if the total value exceeds a certain threshold—$13,610,000 as of 2024—an estate tax return will need to be filed.

Inheritance tax, on the other hand, is paid by the person receiving the inheritance. There's no federal inheritance tax in the U.S., but if you're in one of the six states that do have this tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania), you might need to pay, depending on your relationship to the deceased and the value of what you've inherited. 

Inheritance tax only applies if your inheritance surpasses certain exemptions, which vary by state and relation to the deceased. Closer relatives tend to get more favorable treatment, with exemptions or lower tax rates. In general, life insurance payouts are not subject to inheritance tax—though there are exceptions.

A way to bypass some of these taxes is by gifting wealth to beneficiaries before death. Most states won't tax these gifts, allowing wealth to be transferred in small batches without the added tax burden—just keep in mind the federal gift tax rules.

Understanding 2024 Gift Tax Rules

To keep up with inflation, the IRS announced new exemption amounts for gift tax in 2024. The annual gift tax exclusion is now $18,000 per recipient—the highest it’s ever been. This means you can give away up to $18,000 to as many people as you like without paying gift tax.

What does this mean for married couples looking to pass on their wealth? A couple can now shield up to $27.22 million from federal taxes by combining the 2024 gift and estate tax exemptions.

Morgan Lewis illustrates these laws with an example: “If a married couple has three children and five grandchildren, they may transfer $288,000 in 2024 to their descendants without touching their combined $27.22 million gift and estate tax exemption, thus allowing them to transfer further substantial assets gift-tax-free.” This strategy doesn't just benefit the recipients today; it also avoids future estate taxes on the appreciation of those assets.

A crucial point to remember is that while the exemption amounts are high now, they're set to revert to half their size in 2026. This looming change adds a layer of urgency to estate planning, encouraging individuals to make the most of these generous exemptions while they last. 

How to Save Taxes on Inherited Stocks

If you inherit stocks that have climbed in value over the years, you're facing a potential tax headache on those gains, right? Not necessarily, thanks to a tax law provision called the basis step-up.

Normally, capital gains tax—a tax on the profit from investments sold—is based on the difference between the sale price and the purchase price (also known as the cost basis). Sell for more than you bought, and you owe taxes on the gain. 

However, when it comes to inherited stocks, the tax rules pivot in your favor. Instead of the original purchase price, the cost basis for inherited stocks is often reset to the fair market value of the stocks on the date of the original owner's death. Alternatively, the estate might opt for an alternate valuation date, six months post-death, potentially adjusting the cost basis further.

“Let's say a person purchased Walmart stock at the beginning of 1980 when it was trading at a split-adjusted price of roughly $0.08 per share. If they sold that holding shortly before death 40 years later, a substantial amount of income tax would be due because of gains the stock had made through the decades. However, if that stock was instead bequeathed to an heir, the cost basis would be reset,” explained Keith Noonan for The Motley Fool. This means all that growth over decades potentially escapes capital gains tax, significantly reducing the tax burden for the heir when they decide to sell the stocks.

Conclusion

Navigating the complexities of inheritance and gift taxes requires a blend of knowledge and strategy. The IRS's 2024 adjustments to gift tax rules offer opportunities for tax-efficient wealth transfer, which demonstrates the importance of staying informed on annual exclusions and exemptions. Additionally, the basis step-up rule for inherited stocks offers huge potential savings in capital gains taxes for heirs. Embracing these insights can guide you through the financial implications of inheritance—but the best person to turn to is always an experienced professional, who can give you the best information about your individual situation.

Sources

IRS

Investopedia

Morgan Lewis

The Motley Fool

Dan Nicholson is the author of “Rigging the Game: How to Achieve Financial Certainty, Navigate Risk and Make Money on Your Own Terms,” deemed a best-seller by USA Today and The Wall Street Journal. In addition to founding the award-winning accounting and financial consulting firm Nth Degree CPAs, Dan has created and run multiple small businesses, including Certainty U and the Certified Certainty Advisor program.

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