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5 Ways to Protect Your Inheritance from Taxes Thumbnail

5 Ways to Protect Your Inheritance from Taxes


Just like you pay income taxes on the money you earn, your beneficiaries will pay taxes on the money you leave them if you don’t plan it right. While federal taxes don’t become an issue until an estate is worth over $11.7 million, certain states' tax inheritances and any inheritance over $11.7 million will incur federal and state taxes.

Fortunately, there are ways to protect your inheritance from taxes, ensuring your loved ones receive more money in their pockets. 

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1. Choose an Alternative Valuation Date

Most inheritance values are based on their value on the date the person died. Typically, the value doesn’t matter since inheritances aren’t taxed on a federal level unless it’s worth more than $11.7 million (for 2021). 

If the estate is worth more than $11.7 million and the estate is worth considerably less six months after the date the owner died, an alternative valuation date may save your beneficiaries a lot of money in tax liabilities.

To qualify, not only must the estate be worth less on the 6-month anniversary of the death, but the alternate date must decrease the total amount of taxes due.

Why consider this option?

You’ll lower the tax liability, which means more money in your pocket from the inheritance. But like any tax issue, there is a downside.

If you choose the alternate valuation date for one asset, you must use it on all assets within the estate. This means even if other assets didn’t decrease in value in the six months following the death, you have to use the value on that date which may decrease the value of the inheritance and result in lower savings.

The executor of the estate must choose to use the alternate valuation date. The executor must choose to do so within one year of the due date of the tax return. Once you make the decision, you cannot change your mind.

2. Set Up an Irrevocable Trust

An irrevocable trust is a great way to protect your estate from taxes, but use caution because, as the name suggests, you can’t change it once you set it up. Any assets you put into the trust become the property of the trust, not your estate any longer. This decreases the tax liability your estate owes.

When you set up an irrevocable trust, you cannot be the trustee. You must appoint a third party to take control. The trustee then controls the trust and the assets in it. Since the trust isn’t tied to your estate, it doesn’t die with you - the trust lives on as you stated in the instructions.

The trust must file taxes, but since the trust lives on, there aren’t any taxes due. This is an excellent option for large estates that would otherwise trigger a federal tax liability.

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3. Give Gifts

You don’t have to wait until you die to give your beneficiaries parts of your estate. You can give a single person up to $15,000 without triggering a tax liability or up to $30,000 if you're married filing jointly.

You can give up to $11.7 million in your lifetime before triggering a gift tax. This means you can give away money annually to each of your beneficiaries, paying attention to the annual limits since they change each year until your estate is worth less than the $11.7 limit that would trigger a federal tax liability.

4. Strategize Your Retirement Accounts

If you plan to leave your retirement accounts to your beneficiaries, be careful because all distributions could be taxed if you don’t plan it right. While the accounts aren’t taxed until your beneficiaries take distributions, they’ll be required to take distributions, called Required Minimum Distributions, which are taxed.

If you convert your IRAs to Roth IRAs, you can protect your beneficiaries from the tax liability. But, doing this will trigger a tax liability on your part, so be careful that you don’t put yourself in a higher tax bracket by making too many conversions at once. 

Converting the retirement accounts to Roth accounts will eliminate the tax liability your heirs will owe and allow them to withdraw funds at their own pace rather than as Required Minimum Distributions.

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5. Give Money via a Life Insurance Payout

If you have a large estate, you can protect the inheritance by giving the money as a life insurance payout versus a direct transfer of assets. All life insurance payouts are tax-free at face value. If your beneficiaries don’t cash it in right away and the account earns interest, however, they will owe taxes on the interest earned, but it’s much less than the tax liability on the full inheritance (face value of the life insurance).

FAQ - Ways to Protect Your Inheritance From Taxes

How Much Can You Inherit From Your Parents Without Paying Taxes?

It doesn’t matter if you inherit money from your parents, grandparents, or a complete stranger. The taxation is the same. If the estate is worth more than $11.7 million, it triggers a tax liability unless you use one of the methods above to protect it.

Does the IRS Know When You Inherit Money?

The IRS doesn’t receive notice that you received an inheritance, but it’s the law to report any income you receive. If you don’t claim it, but there’s a red flag somewhere along the way, and the IRS conducts an audit, it could work against you.

Are Inheritances Considered Income?

For federal tax purposes, inheritances are not considered income. It’s the interest earned on the inheritance that triggers a tax liability as long as the estate is worth less than the federal limit that year. If it exceeds that limit, it incurs taxes immediately if the steps above are not utilized.

Any inherited income that produces income - selling a property, earning dividends on a stock, or taking retirement distribution after death are tax triggers.

Do You Get a 1099 for an Inheritance?

Generally, you will not receive a 1099 for an inheritance. Still, if you receive a payout after the death from a retirement account, for example, the sponsor will send you a 1099 for the amount you cashed out as that amount is taxable in the year you took it. 

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The Bottom Line

It’s best to work with a financial advisor when setting up your estate for your beneficiaries. If you want to protect your inheritance from tax liabilities, you need to set it up, so they are protected.

You may have to give money while you’re alive, set up a Roth retirement account, or set up an irrevocable trust. Your executor may also choose to use an alternate valuation date after your death if the assets values drop, and they can save money on the tax liabilities.