One of the greatest advantages in estate planning is that you’re the ultimate authority when it comes to deciding who gets your property -- and who pays inheritance tax on the transfers. In most states, inheritance tax isn’t an issue, but among those that do impose this sort of levy, the individual who receives the inheritance is responsible for paying it. This is different from an estate tax, which is levied against your estate based on the total value of all the property you owned. Inheritance taxes are based on the value of the gift.
The Terms of Your Will
The executor you name in your will, who is the individual who manages your estate throughout the probate process, may elect to pay the inheritance tax on behalf of your relative. But you don’t have to leave this to chance or trust in your executor’s discretion. You can include specific language in your will, requiring him to do this. In effect, you would be paying the tax for your relative because the money would come out of your estate.
Not Everyone Has to Pay
Not only do most states not have an inheritance tax, but those that do usually exempt some relatives from having to pay it. The tax rate decreases the more closely related the deceased is to a beneficiary. For example, in Pennsylvania, direct descendants, including children, grandchildren and great grandchildren, pay only 4.5 percent. Siblings must pay 12 percent, while everyone else pays 15 percent. New Jersey has an inheritance tax, but direct descendants, parents and grandparents are exempt. Siblings, sons-in-law and daughters-in-law of the deceased pay 11 percent on a home’s value above $25,000 -- and the rate gradually increases as the value of the home goes up. Nieces, nephews, cousins, and more distant relatives must pay 15 percent of the property’s value up to $700,000, and 16 percent if the home is worth more than this. Depending on how much your home is worth and how closely related you are to your relative, the tax bill could be significant. If your will specifically instructs that your estate should pay the tax, it might possibly deplete the inheritances you left to others.
The Alternative of Gifting
If you give the home to your relative during your lifetime, this also shifts the tax burden from her to your estate. Gifting can avoid an inheritance tax, but it may incur a gift tax. In states that permit this means of avoiding the inheritance tax, some rules generally apply. For example, in Pennsylvania, you must outlive the transfer by a year. The federal government imposes a gift tax, but it offers exclusions so the transfer may not deplete your estate. As of 2014, you can give $14,000 a year to any single individual tax-free. You can apply the lifetime exclusion to the balance of your home’s value over $14,000; this exclusion is $5.34 million as of 2014. The lifetime exclusion also applies to your estate, however, shielding it from estate taxes. The amount left to protect your estate would be reduced by your home’s value over $14,000.
Some states, such as Pennsylvania, provide an inheritance tax exemption for property you place in a living trust. The trust must be irrevocable, however. After you transfer the house into an irrevocable trust, you can’t change your mind and take it back. You can draft your trust documents so that you have use of the property during your lifetime, but this might be an extreme measure just to save on inheritance tax. If you have other concerns that an irrevocable trust might also address, speak with an attorney to explore whether this may be an option.