Inheritance Tax Estate Planning
Technically speaking, an inheritance tax is different from an estate tax. The latter is a tax on a decedent’s gross estate, while the former is levied against the share an individual receives of an estate.
For practical purposes, however, taxes on an estate tend to reduce the amount inherited by heirs, devisees, distributees, legatees and beneficiaries — all names for people who inherit. Thus, responsible estate planning involves consideration of both inheritance and estate taxes.
There is no federal inheritance tax, and only 11 U.S. states still collect a tax on inheritances. These states are Connecticut, Indiana, Iowa, Kansas, Kentucky, Maryland, Nebraska, New Jersey, Oregon, Pennsylvania and Tennessee. Adequately planning for the inheritance tax obligations in these states requires a close examination of the tax laws of the individual states.
Issues to consider include whether jointly owned property, property transferred to a surviving spouse, life insurance proceeds and gifts made prior to the decedent’s death are subject to succession or inheritance tax and at what rate. Also, some states, such as Tennessee, exempt beneficiaries of small estates from inheritance taxes.
The federal estate tax is a tax on a decedent’s gross estate, including assets not subject to probate. Most people will not be subject to the estate tax because a standard credit exempts estates below a threshold of more than $1 million (though this amount is subject to frequent change).
To calculate the gross estate, and whether it exceeds the estate tax threshold, all properties in which the decedent held any ownership interest or control, including those properties held in a revocable trust, are added to the cumulative total of taxable gifts made during their lifetime.
The primary exemption from the estate tax is property left to a surviving spouse. As with most inheritance tax states, gifts made within three years of their death are counted as part of the estate for tax purposes. The relatively few states that assess an estate tax closely follow the federal rules and exemptions.
Trusts are the most common vehicle used to avoid estate and inheritance tax. In an inheritance tax state, using a pour-over will to create a testamentary trust can help your beneficiaries avoid inheritance tax, though they will pay income tax on any trust distributions they ultimately receive.
To avoid the estate tax, assets must be transferred to an irrevocable trust in which the settlor has no possession, interest other incident of ownership or be given in a gift that is completed more than three years before the settlor’s death (though a gift tax or generation-skipping tax may apply).
It is common to leave life insurance proceeds to an irrevocable trust, but these will still be subject to the estate tax if the insured retains any control over the policy options.