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Wednesday, February 23, 2011

Taxation on wills and beneficiaries

Taxation of wills and beneficiaries of wills is dependent on state and federal tax law within ones country of primary residence. In the United States, beneficiaries of wills are potentially subject to estate tax, inheritance tax, probate court proceedings, and income tax depending on the value of assets, existence of trusts and types of financial instruments within an estate.

Estate tax is higher than income tax and does not eliminate the requirement of income tax on inherited assets, nor does it eliminate taxation of the deceased via inheritance tax i.e. income tax for the dead. These multiple layers of taxation can potentially cause taxation levels in excess of 80%. For this reason, considering tax related options concerning taxation on will related matters and their beneficiaries is an important element of financial planning.

Ways to reduce beneficiary taxation

In light of the potential for estate, income and inheritance tax a few financial instruments and tax planning techniques can be utilized to minimize and avoid potential and existent taxation of assets passed on to heirs and/or beneficiaries. A few of these tax hedging facts and methods are illustrated below.

• Estate tax limits: Estate tax is applicable only to estates valued between $1 million and $3.5 million depending on the year. The elimination or re-evaluation of estate tax is a matter of political decision and may be best considered as a possible scenario in financial planning.

• Life insurance trusts: Assets held within a life insurance trust are exempt from estate valuation and therefore can serve as a useful hedge against possible estate taxation.

• AB Trusts: AB trusts, unlike living trusts are the property of trust managers with rights to the assets passed on to beneficiaries including spouse and children. Due to the structure of AB trusts, assets held within them are not subject to estate tax.

• Charitable lead and Charitable remainder Trusts: These two types of trusts reduce taxable inheritance, possibly to the point of falling below the taxable estate value limit. These trusts also allow capital gains avoidance, annuity receipt of funds and beneficiary revocation despite the trusts being irrevocable.

• Marital deduction of IRA's: A stipulation with regulation of individual retirement accounts makes possible the deferment of taxation of IRA distributions and inherited value until the death of the beneficiary spouse. This means that if the income is 1) paid in the form of annuity and 2) Is not fully claimed before the death of the IRA owners spouses/beneficiary then taxation of the IRA will be limited and/or reduced. This marital deduction may be facilitated through the rolling over of IRA's. (unclefed.com). The rules regarding this are quite involved and may require the assistance of a financial planner, accountant or attorney.

• Income tax of inheritance: If a beneficiary receives inheritance outside of a tax protected annuity or financial instrument, that inheritance will become subject to income tax. This can be especially costly especially after an estate tax is imposed. For this reason, planning for receipt of inheritance in the form of annuity payments can potentially lower taxation of income.

• Inheritance tax: Inheritance tax is the taxation of the deceased persons estate. Not all states are subject to the inheritance tax, Rhode Island being one such state. However, for residents of other states avoiding the inheritance tax can be assisted via establishment of specific types of trusts that transfer "ownership" of assets but not rights of beneficiaries to the assets and reduction of estate value via annual gift reductions.

• Additional exemptions: To further lower estate value, an estate may be reduced in value by up to $1 million via gift exemption and $2 million for "generational pass over" of beneficiaries. (Themoneyalert.com) An estate tax schedule based on income amount and taxable year is included with the references to this article.

Taxation of assets referred to in wills, within estates and after death have the potential to be very large due to the multiple types of taxation imposed on the deceased, the estate of the deceased and the beneficiaries of the deceased. Financial planning for such taxes can be a very good idea especially in cases where the asset value of an estate is above $1 million dollars or more. The techniques in this article are not exhaustive of all the possibilities for tax planning and do no replace the advice of an accountant or lawyer but serve as a guide to the potential taxation of willed assets and ways in which that taxation can be reduced.


1. http://www.smartmoney.com/tax/homefamily/index.cfm?story=estatetax
2. http://www.nolo.com/article.cfm/objectId/426FB79B-AC11-432F-9E3204F6BAAC7FFD/309/227/QNA/
3. http://www.savewealth.com/planning/estate/charitabletrusts/
4. http://www.unclefed.com/AuthorsRow/TaxBusProf/ira.html
5. http://query.nytimes.com/gst/abstract.html?res=9B03E2D71430E733A25753C1A9679C946397D6CF
6. http://soundmoneytips.com/article/2777-tip-for-avoiding-inheritance-tax
7. http://www.nber.org/reporter/spring06/kopczuk.html
8. http://www.forbes.com/2000/12/08/1208finance.html
9. http://www.hoaglandlongo.com/practices/Federal_and_State_Tax_Planning.cfm