This column first appeared in the San Antonio Express-News and its MySA.com website on April 20, 2015.
Dear Mr. Premack: My parents live in Texas, while I live in California. If I am anticipating inheriting just over $5 million, how does living in California affect the taxes? Do I have to move back to Texas for the lowest tax rate? Is there a tax shelter option, such as owning property in Texas? – K.A.
There are three tax systems about which you should be concerned. First is Texas, and whether the state will impose an inheritance tax. Second is California, and whether the state will impose an inheritance tax. Third is the USA, and whether the country will impose an estate tax.
Texas will not impose an inheritance tax. There used to be a tax based on a credit granted under the Internal Revenue Code. Texas policy was that if the IRS was going to reduce the federal tax, the state would scoop up that same amount for its treasury. There was no actual increase in taxes, just a reallocation to split the tax between the USA and Texas. However, Congress eliminated the federal credit in 2005 and Texas has taken no action to re-institute an inheritance tax.
California will not impose an inheritance tax. First, while you are a California resident, your parents live in Texas. Their money and property are in Texas. California thus has no jurisdiction over their assets, and cannot impose a tax on their estates. Inheritance taxes are actually paid by the estate’s Executor on behalf of the estate, and are owed by the estate not by the heir. Second, like Texas, California’s tax was eliminated in 2005 when the federal law was changed.
The USA does still impose an estate tax. The exemption amount is currently $5,430,000 per person. Federal law allows an unused exemption to be carried forward to a surviving spouse. Thus, if done properly, your parents are entitled to pass $10,860,000 to their heirs without paying any federal estate tax. However, if your parents’ combined estates are less than $5,430,000 there is no need for either of their estates to report or to pay any estate tax.
An additional tax benefit to consider is the free step-up in basis. When both of your parents have died, your new tax basis is set to the value of each asset on the date of the last to die. This means that you will not be exposed to the same capital gain taxes to which they would have been exposed if they liquidated investments during their lifetimes.
Your inheritance is also free of income tax, with the exception of items on which your parents never paid income tax. If you inherit an IRA, income taxes will be due as you make the required withdrawals. But you do not report inherited assets as income on your 1040. If you inherit a $100,000 certificate of deposit, the inheritance is not included in your adjusted gross income. (But after you own the CD and it begins to pay interest to you, that new income must be reported on your federal 1040).
Texas has one advantage over California: we have no state income tax. After you inherit your parents’ $5 million, your annual income will no doubt increase. You will have to pay your federal income taxes, and if you live in California, you will also pay a maximum of 12.3% income tax on those earnings.
Move back to Texas! Enjoy our balmy summers and low taxes. And when you return, don’t forget to see your Texas Certified Elder Law Attorney to make your own estate plan. Your California estate plan must be reviewed and modified to work under Texas law.
Paul Premack is a Certified Elder Law Attorney with offices in San Antonio and Seattle, handling Wills and Trusts, Probate, and Business Entity issues. View past legal columns or submit free questions on legal issues via www.TexasEstateandProbate.com or www.Premack.com.