Federal Inheritance Tax

Federal Inheritance Tax is one of those topics many people don't like talking about, but it is a part of the cycle of life. Possessions have been passed down from generation to generation throughout history, and they provide us with both sentimental and monetary value. Thankfully, we don't have to deal with inheritance issues all the time, but we want to provide some information for those that need it.

Inheritance Tax Law

Depending on where you live, the tax code may make reference to inheritance tax, estate tax, and even a "death duty."  Here in the United States, there is a difference between estate taxes and inheritance taxes.  Estate taxes are levied on representatives of the deceased person, while inheritance taxes are levied on the beneficiaries of an estate.  Elsewhere in the world, the terms estate tax and inheritance tax are used interchangeably.

Some individuals mistakenly believe there is a separate inheritance tax rate in the United States.  IRS tax law, or tax code, does not provide for a special inheritance tax rate, instead there are exemptions and credits that apply to property that is inherited or gifts that are received.

Under the current law, the IRS has a prescribed method for determining if any inheritance tax is due on property or monies received.  We are going to briefly describe this method in the section below.  Keep in mind the settling of an estate is a complex matter.  An attorney or tax accountant should be consulted in situations where matters of the law are concerned such as the contesting of a Will, known as the probate process.

Inheritance Tax Basis

The first step used to determine the amount of inheritance tax that might be due is to calculate the fair market value of the entire estate.  This would include cash, bank accounts, stocks and bonds, real estate, insurance, and similar items of value.  The total fair market value of all these items is termed the Gross Estate.

Adjustments to Gross Estate

The next step would be to calculate any adjustments to the gross estate. Typical adjustments include paying-off the remaining balance on a mortgage, or the fees associated with settling the estate.  This last item might include costs such as estate administration fees or payments made to an attorney.  Finally, there is also a Marital Deduction that can be taken for property that is left to a surviving spouse.

Net Value of Property

Once all the deductions have been taken from the gross estate, the remaining balance is considered the net value of the property, or the inheritance tax basis.  To calculate whether or not any inheritance tax is due; the net value of the property must be subtracted from the inheritance tax credits appearing in the tables below.  If the net estate is larger than the tax exclusion, then the federal income taxes due can be found on the standard tax brackets or tax rate tables published by the IRS.

Taxing of Life Insurance Proceeds

Life insurance proceeds paid to you are used in the calculation of the gross estate.  The value of any insurance received is subject to the unified credits and inheritance tax exemptions explained later.  This last statement is true if you elect to receive the proceeds in the form of a single lump sum.

If you elect to receive life insurance proceeds in installments, then you need to separate the value of the insurance inherited from the total of all payments to determine your federal tax liability.  For example, you may be able to elect to receive a lump sum of $100,000 or $10,000 per month for 12 months.  The difference between the lump sum payment, and the money received over time, is due to interest you are earning on the policy by taking installments.

In this example, you are receiving a total of 12 x $10,000 or $120,000, which is $20,000 higher than the lump sum of $100,000.  This means you would need to pay income tax on the $20,000 received in the form of interest income.

Unified Credits, Gift Tax and Estate Tax

The Unified Credit is used to eliminate or reduce your tax liability.  The credit applies to both gifts that may have been given and estates that will be inherited.  The credit is termed a lifetime credit because as each gift is given or an estate inherited, the credit is consumed.  The lifetime credit applies to all inheritance or gifts received since 1977.

The annual gift tax exclusion, estate / inheritance tax exclusion and the unified tax credit for the years 2004 through 2012 appear in the table below:

Gift Tax Exclusion and Lifetime Estate / Inheritance Tax Table

The annual gift tax exclusion applies to each person receiving a gift.  Married couples can each provide gifts to the same person.  For example, in the tax year 2012 married couples can provide a total gift of $26,000 ($13,000 x 2) to one person and remain within the exclusion.  As gifts are made, the unified credit is reduced by the amount of taxes that would have been paid when gifts in excess of the annual gift tax exclusion are made to individuals.

The inheritance tax tables are used to determine the federally-taxable portion of your inheritance.  As previously mentioned, they apply to the net estate you've inherited, not the gross estate or fair market value.  Estate taxes are due nine months following the passing of the original property owner.  The estate will be settled when a closing letter from the IRS is received confirming the acceptance of the tax forms submitted.

Again, if the estate is large enough to qualify for inheritance tax, the advice of an attorney or accountant specializing in estate taxes should be consulted.  Additional information on this topic can be found on the IRS website.

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