What Can I Do to Protect My Inheritance From Taxes?

by Fraser Sherman, Demand Media Google

    A large inheritance won't do you much good if state or federal taxes devour most of the money. For most Americans, this isn't an issue, because most estates aren't large enough to pay either state or federal estate tax. If your inheritance is at risk, you can work with your parent -- or whomever you expect to inherit from -- on ways to reduce the tax bite.

    Research

    Do some research before you act, because it's possible you have nothing to worry about. The federal estate tax has varied wildly in the 21st century as Congress has tinkered with it, but it hasn't applied to estates worth less than $1 million. Only a couple of states levy estate taxes on smaller estates. As of 2012, only seven states -- Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania -- impose state inheritance taxes.

    Gifts

    One person making a gift to another pays the federal gift tax, but as of 2012 the IRS allows you to make a gift of up to and including $13,000 per year to as many recipients as you desire without paying gift taxes. So, if your uncle gives you $10,000 out of your future inheritance this year, neither he nor you will pay a federal tax on it. If he does that each year over a decade, he's trimmed his estate down by $100,000. If you're comfortable bringing up the subject, talk to your benefactor about using this approach to save you estate or inheritance taxes.

    Trusts

    If your mother places assets in a revocable trust, it won't protect them from estate taxes. Other types of trust can do this: With an irrevocable trust, the assets no longer belong to her, so they're not part of the estate. If your parents are both alive and married, an AB trust offers another alternative. When your mother dies, she transfers her assets to the trust, but your father can use them until he passes on. By splitting your mother's assets from your father's you have two separate pots of money, each of which may be low enough to avoid estate tax when your father dies.

    Disclaiming

    Disclaiming your inheritance -- turning it down and letting it pass to the next heir in line -- is a drastic step, but it's sometimes a smart one. Suppose you inherit property from your aunt that's subject to inheritance tax. In that case, disclaiming and allowing her son to inherit may mean he pays a much lower tax rate. If you're financially secure and close to your cousin, that might be the best choice. There are sometimes other tax advantages: If you are ill and likely to die soon, disclaiming keeps the property from being part of your taxable estate.

    About the Author

    Fraser Sherman is a former reporter with the "Destin Log" newspaper and now freelances full-time. His work has been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life," and he's the author of three film reference books, including "Screen Enemies of the American Way." He specializes in finance and tech articles.