If you have a significant amount of assets that you want to pass on when we die, you may wonder how much your heirs will lose to the inheritance tax. Unfortunately, inheritance tax laws vary from state to state and If you are inheriting assets or property from someone, your inheritance may be subject to state taxes. Therefore, understanding how these apply to your location and impact your situation is crucial.
In this article, we’ll dig the basics of the inheritance tax and walk through different tactical approaches you can take to maximize your hard-earned gains you pass onto future generations:
- Give the assets to the beneficiaries as early as possible.
- Set up specific types of trusts:
- Pass money to next generations free of estate taxes and without using your lifetime gift exemption with a Grantor Retained Annuity Trust (GRAT) or combine GRATs with direct indexing to maximize the GRAT’s volatility and increase returns by even 98% or more.
- Pass wealth down over the generations in a tax-advantaged way with a Dynasty Trust.
- Use CLATs to pass on assets to future generations and charitable causes while avoiding estate taxes and not using your limited gift exemption.
- Pass your assets on to your beneficiaries via a trust in a state with no state income, capital gains, dividend/interest and inheritance/estate taxes.
But first, let’s start with the basics of what the inheritance tax is.
Inheritance Tax Overview
The inheritance tax is a tax on the transfer of assets from a person to their beneficiaries and is taxed to the beneficiaries of the assets. The tax is calculated on the value of the assets when they are gifted, and the tax rate is typically based on the value of the assets being inherited by the beneficiary, the relationship between the estate owner and the beneficiary, and the state they live in.
How Does It Work?
When a person dies, their assets are distributed according to the terms of their will, or if they did not have a will, according to the state’s laws. Depending on the value of the assets and the beneficiary’s relationship to the deceased, these gifts may be subject to paying inheritance tax.
There is no federal inheritance tax, but some states have a tax on inheritances. However, even in states with an inheritance tax, it does not apply to any assets distributed to their spouse, specific types of assets, and particular other beneficiaries based on each state’s rules.
Need some help to understand the most convenient tax planning structure to reduce your inheritance taxes? Our team of tax-planning experts can help!
What states have to pay the inheritance tax?
The six states that impose an inheritance tax are:
- New Jersey
What is the Inheritance Tax in Arkansas?
Since Arkansas is not a state that imposes an inheritance tax, the inheritance tax in 2023 is 0% (zero). As a result, you won’t owe Arkansas inheritance taxes.
What’s the difference between inheritance tax and estate tax?
The inheritance and estate tax are taxes on the transfer of assets from one person to another, but they are assessed differently. The estate tax is imposed on the estate of the deceased person or the person passing on the assets before they are distributed to heirs, and it is calculated on the total value of the assets when they are passed on. On the other hand, the tax on estate inheritance is imposed on the beneficiaries of those assets when passed on.
Another critical difference between the inheritance and estate tax is that there is no federal tax, and only some states impose an inheritance tax. On the other hand, there is a universal federal estate tax, and some states impose a state-level estate tax.
How to Avoid Inheritance Tax in a state where an inheritance tax is imposed
There are several ways to maximize what you pass on to future generations and avoid or reduce the amount of inheritance tax owed. Here are the three key to consider:
- Give the assets to the beneficiaries as early as possible. This allows the appreciation of the assets to avoid the inheritance tax, also allowing to compound wealth efficiently.
- Setting up specific types of trusts can allow your assets to be passed on without being subject to the estate tax. Two common trust structures used to do so are:
- Grantor Retained Annuity Trust (GRAT): With a GRAT, you can place assets into the trust, any appreciation above a set percentage will pass to your beneficiary’s estate tax-free, and you won’t use up any of your lifetime gift exemption. As a result, you can substantially reduce the size of your taxable estate while passing on assets to your heirs. To get even better returns, you can use Valur’s Direct-Indexed GRATs, where instead of buying a single index fund and placing it in a GRAT, you’d follow a direct index strategy and open up separate GRATs that would own each individual stock in the index (an important comment here: the cost of +500 Valur GRATs is comparable to the cost of 1 or 2 GRATs from a traditional service provider!). By doing so, you can take advantage of several features of GRATs to yield far greater returns — 98% higher over the last 20 years. In fact, as a result of the basic rules of GRATs, it’s impossible for the combination of direct indexed GRATs to perform worse than a single GRAT that owns the same stocks via an index fund. Sounds too good to be true? Check out our direct Indexing GRATs case study or set up a call to learn more.
- Dynasty Trusts: These structures are designed to help individuals and families preserve their wealth, reduce or avoid estate and inheritance taxes, and ensure that assets are managed and distributed according to their wishes over multiple generations. A dynasty trust is particularly a good choice for families that want to transfer significant wealth from generation to generation. Even then, though, recall that dynasty trusts are irrevocable, so they may not be a good fit if your family’s needs may change, or if the family dynamics are unsettled to the point that you cannot write distribution rules that will work for the foreseeable (and unforeseeable) future. If you´d like to learn more, please check our Dynasty Trusts article here.
- Charitable Lead Annuity Trusts (CLATs): CLATs are irrevocable trusts designed to reduce a beneficiary’s potential tax liability. They are best suited for those looking to mitigate a major tax exposure AFTER income is received,.The CLAT strategy is relatively simple: the grantor places money into the trust, receives an up-front tax deduction, makes a donation to charity every year of the trust’s term, and then the donor or another designated beneficiary receives the remainder of the assets after the final charitable contribution.
- If you already have an established trust in a state where the inheritance tax is imposed, moving it to a state like Nevada or South Dakota provides a tax-efficient and convenient means of wealth preservation and succession planning. Firstly, individuals can minimize the financial burden on both the grantor and beneficiaries. The absence of state income tax ensures that any income generated within the trust is not subject to additional taxation. Additionally, the exemption from inheritance and state estate taxes ensures that the transfer of assets to heirs remains tax-efficient, safeguarding family wealth.
The inheritance tax can be a significant burden for beneficiaries in some states. It is essential to understand if it applies to you, how it works, and the different strategies that can be used to reduce or avoid it. By understanding the differences between inheritance tax and estate tax and the specific rules of the state’s inheritance tax, individuals can plan to minimize the amount of inheritance tax their beneficiaries will have to pay.
Want to dive into inheritance taxes in depth? Contact our team for more information.
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