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    Are inheritances taxable?

    The taxability of inheritances is a mixed bag, but mostly good news for heirs of small estates. However, the types and timing of the numerous taxes are confusing and subject to misconceptions. If you add in the emotional dimension, it's beneficial to understand what to expect well before you are faced with the death of a close relative.

    Personal tax for decedent up until death The confluence of "death and taxes" requires that a final personal tax return be filed for the decedent even after death, reporting any taxable income up until his or her demise, and paying tax if due. For a married couple, the survivor files a "Married Filing Joint" return for the final year including whatever in-come the decedent earned or accrued. For a single decedent, the executor, trustee, or "personal representative" files and signs the final return, including Form 1310 to receive and distribute any refund due.

    Personal tax for heirs at inheritance By and large, assets pass free of personal income tax to the heirs. This includes cash, life insurance proceeds, non-pension financial accounts, and real estate. However, any interest that ac-crues on life insurance proceeds prior to payout is taxable to heirs. The major exception is pre-tax pension accounts such as IRAs. Pre-tax contributions plus all untaxed growth are taxable but exempt from early withdrawal penalties. IRA accounts must be withdrawn and taxes paid within 5 years of inheritance.

    Estate tax for heirs at inheritance If the value of a decedent's total assets exceeds the "exclusion" amount, the overage is subject to a progressive Estate ("Death") Tax of 18 to 48 percent. For 2004, estates under $1,500,000 are not subject to Estate Tax. This exclusion amount will increase through 2010, at which time the tax is repealed. The law "sunsets" that year, continuing in force only if reinstated by Congress. Estate Tax returns and taxes are due 9 months after death.

    Personal tax for heirs at sale of assets Heirs are also subject to capital gains tax on any increase in value of inherited capital assets at the time of sale. This is accomplished by giving heirs a "step-up" in cost basis to the value of the asset at inheritance. That way, they only pay tax on any increase in value while they held it. This also means that it is critical to have assets appraised soon after inheritance.

    Last word Although these dimensions only address federal aspects of inheritances, estates are also subject to state laws for probate and taxation. The larger the estate, the greater impact so-called "estate planning" can have on how much heirs actually receive and how soon they obtain it.

    The above discussion is general in nature and not intended to be considered advice for any individual tax situation.