The estate pays the estate tax, and the beneficiary pays the inheritance tax, although an estate can be set up to pay that cost on behalf of the beneficiary. Not all states in the U.S. have an estate or inheritance tax. The federal government has an estate tax, but not everyone has to pay it. To avoid paying taxes on an estate or inheritance, you can set up at least one type of trust, and you can make other financial moves now so you pay less tax later. This may help protect your assets from taxation—here’s how.

Death Taxes You Can Try To Avoid

Assets in an estate can be taxed more than once, as part of the estate (estate taxes) and then again when transferred to a beneficiary (inheritance taxes, but only in some states).

The Inheritance Tax

The Internal Revenue Service (IRS) doesn’t impose an inheritance tax, nor does it tax inheritances as income. Six states tax inheritances, and one of them—Maryland—taxes both estates and inheritances. The others include Nebraska, Iowa, Kentucky, Pennsylvania, and New Jersey. Your beneficiaries won’t have to worry about an inheritance tax unless you live in one of these six states, or if the property they’ll receive is located there. Beneficiaries who aren’t related to you pay the highest rates. Bequests to spouses are generally exempt. 

The Estate Tax

Twelve states and Washington D.C. impose their own estate taxes:

WashingtonOregonMinnesotaIllinoisNew YorkVermontMaineMassachusettsRhode IslandConnecticutMarylandHawaii 

The federal estate tax only applies to estates that exceed a certain value, $12.06 million for 2022 and $12.92 million for 2023. Once an estate exceeds that amount, the balance is subject to the federal estate tax.

Giving Money Away To Avoid Taxes

Charity

In most cases, you must give to a qualified charity if you’re going to get any sort of tax break for giving your money away. The IRS offers a list of acceptable, qualified charities on its website. You can check it to make sure that the charity you’re considering is covered and that you can claim charitable contributions on your annual tax return. This could help you give away a large amount of your estate and help you get a tax break.

Gifts

You can also give some of your money away as gifts to loved ones each year. As long as you gift less than the annual gift tax threshold, you won’t have to pay taxes. This amount is $16,000 for 2022 and $17,000 for 2023—that’s per person, per year. This can help you lower your total estate value and your inheritance. You can transfer a fair bit of money to your beneficiaries without incurring gift tax if you do this each year for an extended period of years, and you’ll simultaneously reduce the value of your estate. Your beneficiaries won’t have to pay inheritance tax on the gifts if you live in a state that imposes one, because you’re still living. You can subtract the excess of any gifts over the annual limit from your gross estate to lower it so that you can skip the federal estate tax. If your estate is still above that threshold when you die, your estate will have to pay taxes.

How Living Trusts Work With Your Estate  

Trusts are legal entities that hold property that’s eventually transferred to living beneficiaries at the time of the trustmaker’s death. They dodge the probate process but not necessarily estate taxes. There are two basic types of trusts.

Revocable Trusts

A revocable trust—the more common kind—won’t avoid the estate tax. The term “revocable” is key here. The person who makes the trust acts as the trustee and can undo the trust at any time. They can dissolve it, take the property back out of its ownership, or change its beneficiaries. Any income generated by a revocable trust is reported and taxed on the trustmaker’s personal tax return. The trust maker still legally owns the assets funded into the trust, so the IRS considers that it still contributes to the individual’s estate for estate tax purposes when they die.

Irrevocable Trusts

A trust maker who forms an irrevocable trust must step aside after they create it. They can’t act as the trustee or maintain any control over the assets. They must appoint a third party to act as the trustee. They give up ownership of the property funded into it, so these assets aren’t included in the estate for estate tax purposes when the trust maker dies. An irrevocable trust can be a handy way to avoid estate taxes if your estate is large enough to be potentially liable for them, at both the state and federal levels.

Avoiding Taxes With Retirement Accounts 

Retirement accounts can be tricky inheritances for your beneficiaries. Distributions from these accounts are generally taxable, and tax law is pretty strict about when distributions must be taken if you leave your accounts to anyone other than your spouse. Your 30-year-old child wouldn’t be able to sit on the account for 35 years until their retirement, letting it grow and grow undisturbed.  In most cases, your beneficiary must begin taking distributions in the year after your death, and these distributions are taxable as income to them. Exactly how much they must take depends on the method of calculation they use. Distributions can be spread out, resulting in less taxable income per year. They can base distributions on their own age and life expectancy, not yours.  If you leave your retirement account to your spouse, however, they can simply take it over. They wouldn’t have to begin taking required minimum distributions and paying taxes on those distributions until they reach age 72. The account would be treated just as if they had personally owned it all along.

The Unlimited Marital Deduction

All of these rules presume that you’re not outright giving assets to your spouse, either during your lifetime as gifts or via your estate when you die. Spouses are protected by an unlimited marital deduction. You can give everything you own to your partner, or leave everything to them in your estate plan, and no tax will come due—with one exception. Gifts to spouses who aren’t U.S. citizens are limited to $164,000 a year for 2022 and $175,000 for tax year 2023. This limit is also indexed for inflation, so it can increase periodically.

How Capital Gains Taxes Work With Inheritances

https://www.thebalancemoney.com/how-the-stepped-up-basis-loophole-works-357485Gifts to beneficiaries aren’t usually taxable to them as income, but this doesn’t necessarily mean that they won’t be subject to capital gains tax. Consider this hypothetical scenario: You leave your family home to your friend. You paid $80,000 for it many decades ago. It’s worth $400,000 at the time of your death. Depending on where your home is located, your state might want a percentage of that $400,000 as an inheritance tax at the state level. Your friend has a home of their own, and they don’t want to sell it and move back into your home. Nor do they want to rent your home out and deal with being a landlord, so they decide to sell it. Capital gains tax is normally payable on the difference between an asset’s basis—what it cost to acquire it—and the ultimate sales price. If your friend sells the home for $400,000, the capital gain would be $320,000, and they may have to pay capital gains taxes on that amount. They might not realize any gain, however, if you were to pass the home to them as part of your estate plan after your death. The basis is “stepped up” to the date-of-death value for inheritances. They wouldn’t realize a gain if the property were worth $400,000 on the date of your death, and they were to sell it for that amount. The executor of your estate can elect an alternate valuation date for purposes of calculating any estate taxes that might be due. This date is six months after your date of death. This value would be a stepped-up basis of your assets. It would favor your beneficiary if the property were to increase slightly in value during this time.