In Texas, the assets that are left behind after a person dies become part of the deceased's estate, which is distributed to heirs and others through a variety of processes. Sometimes, the assets are subject to probate. If the estate is large enough, then it may have to pay estate tax. In some cases, heirs may have to pay tax, as well, depending upon the type of asset inherited.
Federal and State Estate and Inheritance Taxes
The federal government eliminated inheritance taxes and instituted an estate tax policy that most states, including Texas, follow. In 2011, estates are exempt from paying taxes on the first $5 million in assets. Estates over that amount must pay estate tax on the amount not covered by the exemption, and how big the estate is determines what percentage is paid. The estate’s executor or administrator is responsible for paying the taxes out of the estate’s assets; heirs are generally not liable for estate taxes.
Retirement Account Exception
There is a big exception to the “no inheritance tax” rule, however. In Texas, as well as nationwide, if you are a named beneficiary of an individual retirement arrangement, commonly referred to as an IRA, then your share of the distribution is added to your ordinary income and will be taxed at your personal income tax rate. IRA heirs must take a distribution, subject to certain rules, even if they are not yet of retirement age.
How It Works
When you inherit an IRA, Internal Revenue Service rules state that you must begin taking distributions from the IRA even if you aren’t yet age 59½. You won’t get hit with the 10 percent early withdrawal penalty, unlike other types of early withdrawals, but you will get taxed at your ordinary income tax rate. The best way to minimize the tax impact is to take advantage of the IRS’s life expectancy provision. This states that an heir can spread out the amount he receives from the IRA over his (estimated) life, thus minimizing the amount that’s added to income.
Texas-sized estates also can take advantage of the AB trust if it’s planned for in advance. In an AB trust, a married couple can take advantage of the $5 million dollar estate exemption by signing asset ownership to the trust, which is split in half when the first spouse dies. Most won’t need to take advantage of the AB trust’s provisions, however, because most estates won’t exceed the $5 million national and Texas estate tax exemption. If you decide to investigate the AB trust further, consult a licensed estate planning attorney for advice.