People often have questions about taxes on inheritances, and this is understandable. When you receive income from any source, you typically have to report it when you file federal and state returns. Thus, there is the matter of how capital gains are taxed.
This can seem like a complicated stew that is going to wind up costing your heirs a lot of money. In reality, this is not necessarily the case, and we will provide clarity in this post.
2022 Capital Gains Rates
For tax purposes, there are long-term and short-term capital gains. The dividing line is one year of possession of the assets before a gain is realized. In this context, “realizing a gain” is a term to describe the act of selling the appreciated assets at a profit.
Short-term capital gains are taxed at your regular income tax rate. The long-term capital gains rate is based on your taxable income. In 2022, single people that claim up to $41,675 are completely exempt from long-term capital gains taxes. As you might imagine, the figure is doubled to $83,350 for married couples that are filing jointly.
Individuals that claim between $41,676 and $459,750 are in the 15 percent capital gains bracket. The figure goes up to 20 percent for high income earners that claim more than $459,750 in 2022.
Step-Up in Basis
From an estate planning perspective, a natural question arises: does an inheritor pay capital gains taxes on gains that accumulated during the life of the decedent?
To explain through the use of an example, let’s say that you inherit stock from your grandfather that is worth $300,000. When he bought the stock years before his passing, it was valued at $100,000.
If he would have sold the stock while he was living, he would have been required to pay the capital gains tax on the $200,000 of appreciation. He never sold the stock because he had tax efficiency in mind when he was planning his estate.
Your grandfather knew that the assets would get a stepped-up basis when they were transferred to you. This means that you would not be responsible for the gains that accumulated while your grandfather was living. In other words, the capital gains would pass tax-free.
Going forward, if you realize additional gains, the capital gains tax would be applicable. To be clear, this would be confined to the increase in value after you inherited the stock.
Income Taxes
While we are on the subject of taxes and inheritances, we should expand the explanation. When someone receives an inheritance, they are typically inheriting after-tax assets. The estate in question is comprised of property that remains after the decedent paid taxes.
As a result, generally speaking, inheritances are not looked upon as taxable income by the IRS. One exception is the distribution of the earnings that are generated by the corpus or principal that is held by a trust.
In addition, the beneficiary of a traditional 401(k) account will be required to pay income taxes on the distributions. Why is this the case? These accounts are funded with pretax earnings, so distributions to the original account holder or a beneficiary are taxable.
Estate Taxes
So far, the info we have passed along is encouraging, but there are challenges for high net worth individuals. The federal estate tax carries a 40 percent top rate, and it can be levied on the portion of an estate that exceeds the exclusion.
In 2022, the exclusion is $12.06 million. Here in Connecticut, we have a state-level estate tax as well with a $9.1 million exclusion. This is the highest exclusion among the 12 states that have state-level estate taxes.
If your estate will be exposed to taxation, there are legal steps you can take to mitigate the burden.
We Are Here to Help!
If you would like to schedule a consultation with a Glastonbury, CT estate planning lawyer from our firm, give us a call at 860-548-1000, and you can use our contact form to send us a message.
Mr. Florin is admitted to practice before the courts of the State of Connecticut and the State of New York. He is also a member of the American Academy of Estate Planning Attorneys, the National Academy of Elder Law Attorneys, the Connecticut Bar Association, and the Fairfield County Bar Association.