Will Your Kids Inherit a Tax Bomb From You?

Inheritance tax. (Vitalii Vodolazskyi/Shutterstock)

You can have good intentions with your estate to pass it on to your heirs. You are sure that they will enjoy the benefits of it and have informed them of it. It is possible, though, that if you have not prepared to get around inheritance taxes, they may not receive nearly as much as you hoped. Enabling your beneficiaries to avoid the tax on inherited money is a part of good estate planning—and you can be sure they will appreciate it.

No Federal Inheritance Tax

The good news is that the federal government does not charge any inheritance tax—but six states do. They are Kentucky, Nebraska, Maryland, Pennsylvania, Iowa, and New Jersey. Each state has an exemption amount, and some people are exempt from the taxes, says PersonalCapital.

Capital Gains Tax on Inherited Property

You will pay taxes, in some cases, on both federal and state taxes for capital gains. This tax is only due after the property sells and there is profit.

• Estate Taxes

The IRS says federal estate taxes are only due for any amounts above $12,060,000 in 2022. The estate tax exemption includes what the IRS calls the "gross estate," which means cash, insurance, real estate, securities, trusts, business interests, annuities, and other assets.

States have a much lower threshold, so you should check with your state to determine the level. There are also several states with inheritance tax and estate tax.

• 401(k)s

Standard financial advice today suggests putting as much money as possible into a 401(k) retirement account. If you have followed this advice, you likely will have a good amount of money stashed away for the future. It is especially true if your employer offered matching contributions, and if your spouse did the same. If you started early and maxed out contributions throughout the years, you could easily have more than $1 million tucked away.

If you die before taking the required minimum distributions (RMDs), your beneficiaries are required to deplete the account within 10 years. Money taken out of retirement accounts is considered income. It means that your heirs could pay a huge amount of taxes for 10 years—at least.

• Health Savings Accounts (HSAs)

A health savings account enables you to put money into a tax-deductible account for medical purposes. It is necessary to have a high deductible health insurance policy with it. The money in an HSA grows tax-free. You do not pay any taxes on money withdrawn for medical purposes. Taxes are due when money is withdrawn for other purposes, and there is a 20 percent penalty if under 65.

If you have a lot of medical expenses, it is unlikely there will be much money left in the account when you retire. Otherwise, it could be a considerable sum.

When the account owner dies—and the spouse is the beneficiary—the spouse receives the same benefits as the owner. The difference is that the spouse does not need a high-deductible health plan. GoodRx says that the spouse can withdraw money as needed for any purpose after they reach 65. Taking money out for health costs is not taxable. After reaching 65, they can use the money as they wish without penalties. Once all the money is withdrawn, the account is closed, and taxes will be due.

If the beneficiary is not a spouse, the account gets treated differently. Instead, it is closed on the day the owner died. The beneficiary will be required to pay taxes on all the money in the account, and no probate proceedings are necessary.

One thing that can reduce the amount received by the beneficiary—and paid in taxes, says MarketWatch—is that the medical expenses for the deceased within the past year get paid out of the account, and there are no taxes on that amount.

When a beneficiary is not named, the account is closed and the money goes to the estate of the deceased. This could mean going through probate court and a good portion of the money will go to taxes. It will be reported on the last 1041 tax return of the deceased.

If you name a charity organization as the beneficiary of an HSA, probate court does not get involved. The transfer takes place free of all taxes.

How to Preserve Your Wealth

One way to preserve your wealth from a retirement account is to make a Roth conversion. Kiplinger suggests making this move when your income is low because you will pay taxes on the amount transferred. Make the move from a tax-deferred account to a tax-free Roth account. It can be especially beneficial for those who retire early in their 50s and early 60s.

• Create a Trust

You can avoid tax on inherited money if the deceased places the money into a revocable trust with a pour-over will. Nolo says that this type of will moves all of your remaining assets not already in the trust into it. Nolo also points out that the assets already in the trust can be distributed quickly. The items put into the trust must be approved by a probate court and cannot be distributed until approved—which could take a few months.

Money distributed from a trust is not subject to inheritance tax, but any interest earned is taxable. Investopedia says that when money is distributed from a trust, beneficiaries are given a K-1 form, which shows how much money is principal and how much is interest on the principal.

• Reduce Taxes by Gifting Money

One way to reduce the amount of taxes you pay—and your future beneficiaries—is to give away some of your money while you are still alive. The amount you give is tax deductible, and the recipient does not need to pay taxes on gifts. TurboTax says that you can give gifts to as many charitable organizations or people as you want—up to a limit. For 2022, NerdWallet says that the gift limit for 2022 is $16,000 per person. You can give away money up to the federal exemption amount of $12,060,000.

You can discover the best way your beneficiaries can save money on taxes by discussing the matter with an estate planning attorney. They know the current laws and how to avoid taxes on an inheritance.

The Epoch Times Copyright © 2022 The views and opinions expressed are those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.