Inheritance Tax Management: Preservation Strategies

Estate Planning

Sep 26

Inheritance Tax Management: Preservation Strategies Vision Retirement investing RIA CFP investment management Ridgewood NJ Poughkeepsie NY

You spent decades earning the assets you have today, so you of course want the largest chunk possible to help support the people and causes you care about. Depending on the size of your estate, however, a sizable amount may go to inheritance taxes instead. While taxes are an unfortunate part of life, there’s no reason to pay more than necessary; strategic foresight now can help limit the tax burden on your estate so you can make the most of your legacy.

What are inheritance taxes?

Inheritance taxes are levied when assets are transferred from a deceased individual to his/her beneficiaries. Perhaps you’ve heard of the federal estate tax—which often makes headlines—but inheritance taxes, capital gains taxes, and even income taxes may also apply at both the federal and/or state level when assets are transferred upon death.

While this article covers the basics with respect to this topic, it’s important to note that inheritance taxes exist within a complex web and specific regulations differ significantly by region. To best limit your tax burden, therefore, you’ll want to collaborate with a financial professional who can create a personalized plan tailored to your specific jurisdiction and circumstances.

Decoding tax jargon: different types of inheritance taxes

Several types of inheritance taxes apply when transferring assets; understanding these and how they apply is key to creating a strategy that will keep the tax burden on your estate in check. Let’s discuss each one in more detail…

Estate tax

Estate taxes are imposed on the total value of an individual's estate upon his/her demise and apply to the estate as a whole—in contrast to inheritance taxes, which apply to individual beneficiaries.

The estate can include a broad spectrum of assets ranging from real estate and investments to cash reserves and personal belongings. The associated rate, meanwhile, varies extensively as the estate tax is a progressive tax (just like federal income tax); larger estates are therefore subject to higher taxes.

The federal estate tax in fact doesn’t impact most Americans as the first $13,610,000 is exempt (as of 2024). For those who are impacted, the good news is that strategic options are available to help limit the tax burden (which we’ll discuss later).

Beyond the federal estate tax, several states also impose a state-level estate tax. As of 2024, this includes Connecticut, D.C., Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. Both rates and exemptions vary by state (e.g., Oregon imposes a tax on estates over $1 million, while Connecticut matches the exemption set by the federal government).

Inheritance tax

Inheritance taxes apply to the beneficiary (unlike estate taxes, which apply to the estate as a whole). While no federal inheritance tax exists, several states impose their own inheritance taxes including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania (Iowa, however, plans to phase out its inheritance tax for any deaths occurring after 2024).

Inheritance tax nuances include tax rates that vary by state and exemptions that often extend to spouses, direct descendants, or specific asset categories up to predetermined thresholds. Such differences underscore the importance of tailored tax planning.

Capital gains tax

Capital gains tax is levied on profits realized from the sale of assets such as stocks, real estate, or valuable possessions. The corresponding tax rate varies at the federal level based on an individual’s total taxable income for that year, and some states also have their own capital gains taxes as well. Additionally, some assets—such as retirement accounts and life insurance proceeds—have different tax treatment altogether.

The good news is that when an individual inherits assets—whether stocks, real estate, or other investments—they typically receive a stepped-up cost basis. This means the value of assets is adjusted to their market value at the time of inheritance, effectively resetting the baseline for capital gains tax purposes.

For example, if you inherit stock that was purchased for $1,000 but is valued at $10,000 at the time of inheritance, your new basis for calculating capital gains tax is $10,000. If you sell that stock later for $15,000, you only owe capital gains tax on $5,000 (the profit made after inheriting the asset).

One strategy to potentially minimize the impact of capital gains tax on inherited assets is to hold onto them for an extended period of time; while short-term capital gains tax rates are typically applied to assets held for a year or less, beneficiaries can potentially qualify for long-term capital gains tax rates (which are typically more favorable) by waiting a year or more to sell assets.

Income taxes

Income taxes rarely apply to inherited assets, but they’re still worth a brief mention. Most inherited assets—including life insurance, investments, and bank account assets—are not considered taxable income when inherited, but some exceptions to the rule exist. For example, if a beneficiary decides to withdraw funds instead of rolling them over into a pre-tax account (for pre-tax contributions and taxed withdrawals, such as a 401(k) or traditional IRA), that income is taxable.

Tax implications across inherited assets

Different inherited assets come preloaded with different tax considerations. While not a complete list by any means, the following reflects some of the most common inherited assets and related tax implications.

Cash and bank accounts

Inheritances in the form of cash assets entail relatively straightforward tax implications, subject to inheritance or estate taxes as dictated by jurisdictional regulations. Meticulous documentation and valuation are imperative, however, to ensure compliance and accurate tax liability assessment.

Real estate

Inheriting property can trigger intricate tax considerations, particularly when accounting for appreciation in asset value since the time of acquisition. Beneficiaries may also find themselves navigating estate or inheritance taxes commensurate with the fair market value of the property at the time of inheritance.

Investments

Investment portfolio inheritance introduces an entire gamut of tax complexities, with considerations spanning asset type, cost basis, and prevailing tax rates. Engaging financial advisors and tax professionals can help optimize tax efficiency while safeguarding inherited wealth from undue tax burdens.

Retirement accounts

Inherited retirement assets, such as IRAs and 401(k) plans, present unique tax challenges for beneficiaries. More specifically, income tax obligations accompany withdrawals from these accounts—with penalties looming large in the event of non-compliance with distribution regulations.

Business interests

Inheriting a stake in a family business or closely held entity necessitates astute tax planning to navigate valuation complexities and minimize tax exposure. Thankfully, trust structures and buy-sell agreements offer avenues for a tax-efficient wealth transfer while ensuring continuity in business operations across generations.

Life insurance policies

Life insurance, one of the most straightforward inheritable assets from a tax perspective, isn’t considered taxable income and estate taxes don’t apply. The only potential tax burden? If beneficiaries opt for the installment payment option.

Safeguarding your inheritance: tax-mitigation strategies

Proactive estate planning lays the groundwork for effective inheritance tax management, empowering individuals to minimize tax liabilities and streamlining wealth-transfer processes. While each plan is unique, some key strategies to consider are leveraging tax-advantaged accounts, gifting, and creating trusts. Let’s touch briefly on each one…

Harnessing tax-advantaged vehicles

Leveraging tax-advantaged accounts, such as Roth IRAs and health savings accounts (HSAs), help beneficiaries shield inherited assets from taxation via judicious contributions and strategic asset allocation; individuals can thus optimize tax efficiency and preserve wealth for future generations.

Creating a gifting strategy

The gift tax serves as a bulwark against circumventing estate tax liabilities via preemptive asset transfers. The good news? As exemptions exist for charitable donations and smaller gifts, high-net-worth individuals can engage in philanthropic giving as a tax-deductible way to support causes they care about and maximize their legacy. Those with inherited assets can also use this as a way to limit the tax burden on assets they’ve received.

Another related strategy is to give small gifts to beneficiaries, noting that gifts of up to $18,000 per person, per year are exempt from the gift tax (as of 2024). Those with many beneficiaries who gift the full exempt amount each year can ultimately decrease the amount of their taxable estate over time—with the added benefit of providing support to beneficiaries when they need it most.

Embracing asset protection measures

Different types of trusts can help decrease the amount of one’s estate for estate tax purposes. For example, irrevocable trust assets are technically owned by the beneficiary rather than the original owner and are therefore no longer part of the estate. Trusts also safeguard inherited assets for the intended beneficiary, mitigating external liability risks.

The takeaway: informed wealth transfer decision-making

Collaborating with experienced legal, financial, and tax advisors is an indispensable way to navigate rocky inheritance taxation terrain and thus ensure the preservation of your wealth for generations to come.

Still have questions about inheritance tax? Schedule a FREE Discovery call with one of our CFP® professionals.