When a loved one dies, there are a lot of things to worry about, from planning the funeral to dealing with your own emotions. As is often the case though, money is a major part of the calculus of life when dealing with a recently deceased family member. When they pass, your family will have to deal with their money, assets and debts. And if they have a large enough estate, you’ll potentially have to worry about the estate and inheritance taxes. There are things you can do now, though, that will limit the amount of money ultimately subject to these taxes, so that your family can use more of your wealth to build their own lives. For help with the estate tax or any other financial planning issues, consider working with a financial advisor.
Understanding the Differences Between Estate Taxes & Inheritance Taxes
First things first, make sure you know the difference between the estate tax and the inheritance tax. The estate tax, sometimes called the “death tax,” is money taken by the government from the estate of a recently deceased person before it’s passed on to their family, friends and other beneficiaries. There is a federal estate tax, while a number of states also levy their own estate tax.
The inheritance tax, meanwhile, is levied on money after it has passed on to an heir. Money can be subject to both inheritance and estate taxes. There is no federal inheritance tax, but a number of states levy inheritance taxes.
The rules for these inheritance taxes vary from state to state. Sometimes the inheritance tax only applies based on the state the heir lives in, though it can also matter what state the person who died was living in as well. Even what state the property, like a house for example, you inherit is in can affect the situation.
There are plenty of strategies to decrease both types of taxes. For more details on how to decrease potential estate taxes, check out this article.
Inheritance Tax Avoidance Strategies
If you think you’ll be getting an inheritance when a loved one dies, the first thing you should do is check the laws in both the state you live in and the state they live in. If neither of them levy an inheritance tax, you’re in the clear. Whenever your loved one dies, there will be nothing for you to worry about. There may be an estate tax to deal with, but you’ll pay nothing on any money you actually receive.
If there is an inheritance tax to consider, though, there are some things you can do to decrease your tax burden. Keep in mind that some of these steps will require advance planning and cooperation with the person leaving you the inheritance. So if you believe you’ll be getting an inheritance, think ahead and talk with your family member about the most efficient way to transfer money.
Arrange to Receive the Money as Gifts
If you’re going to be getting an inheritance from a relative who is getting older, consider talking to them about getting some of it as gifts before they die. Currently, the annual gift tax limit is $15,000, so a person can give up to $15,000 to a person each year with no tax implications.
Let’s say your grandmother has told you she’ll be leaving you $45,000 in her will. If, instead of willing you this money, she gave you $15,000 a year for three years before she passes, the money would not be subject to inheritance tax. Plus, you could invest it in stocks or index funds and end up with more money by the time she actually passes away. If it makes your relative feel better, you could even promise not to touch the money until they’re gone.
Use an Alternate Valuation Date
Not all inheritances are cash, as many people receive property, including homes and other real estate. Generally, the property value used for inheritance tax purposes is the date of death. If the estate is also subject to the estate tax, though, using a later date – generally six months after death – may be an option. This could result in a lower property value and thus, a smaller tax burden.
Buy a Payable on Death (POD) Life Insurance Policy
If you set up a payable on death life insurance policy, your beneficiaries won’t owe any taxes on the money they receive on your death. They can use this money to pay any other inheritance or estate taxes that are levied. Again, this will require some difficult planning ahead of time.
Change Your Residence
This may seem like a drastic step, but for some people it may make sense. Remember, not all states levy an inheritance tax and there is no federal inheritance tax. If you’re at a place in your life where you can move, setting up shop in a state where there’s no inheritance tax could end up saving you or your beneficiaries a pretty penny.
Bottom Line
Inheritance tax is levied on money after it has been transferred to an heir. Most states do not have an inheritance tax and there is no federal inheritance tax. That said, even if you live in a state where there is an inheritance tax, there are several steps you can take to minimize the among of your inheritance that ends up being taken by the state.
While estate planning can lead to some difficult conversations, it will ultimately leave your family in a much better position after you pass. In fact, inheritance tax planning can be just as important as writing a will or setting up a trust.
Estate Planning Tips
- If you or a loved one needs help reducing estate or inheritance tax burdens, consider working with a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re going at estate and retirement planning by yourself, it’s a good idea to prepare fully. SmartAsset has you covered with lots of free online resources that can help you plan for the future. For example, check out our retirement calculator.
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