Is Your Inheritance Taxable?
If you received notice that you will be receiving an inheritance from someone who recently passed away, you may be worried about how that will affect your financial situation. Your main concern may be if your inheritance is taxable and how much you can expect to pay. While the simple answer to the question, is your inheritance taxable, is yes, it’s more complicated than that.
Your inheritance may be subject to multiple taxes. Those taxes will directly influence how much you end up receiving in your inheritance. Inheritance taxes and estate taxes are common but not required by every state. Whether estate or inheritance taxes are applicable depends on which state the decedent lived in.
The inheritance tax is the first to consider. Only six states require an inheritance tax. They are:
- New Jersey
The decedent must have lived in one of these six states for the inheritance tax to be imposed. If you lived in one of these states and the decedent lived elsewhere, you won’t be responsible for this inheritance tax. It’s also important to note that there is no federal inheritance tax.
Estate taxes are the second type of tax that may be required from an inheritance. Unlike the inheritance tax that you are responsible for, the estate pays the estate tax before the remaining amount is distributed to the heirs.
Another key difference between the estate and the inheritance tax is that the estate tax can be imposed by both the state and federal governments. The inheritance tax is only levied by the state where it is relevant.
Twelve states require an estate tax while the federal government imposes the estate tax on any estate worth more than a specific amount. For 2022, it is those estates valued at over $12.06 million. Maryland is the only state that requires both an estate and inheritance tax.
Who Pays the Tax?
The beneficiary pays the inheritance tax after they receive the funds. They are responsible for these taxes in the states where they are collected even if they live in another state. Each beneficiary will pay an inheritance tax, and they may pay different amounts based on how much they are receiving. It also depends on their relationship with the person who is deceased.
The estate tax is paid by the executor of the estate before they disperse the funds to the heirs. The beneficiaries aren’t responsible for these taxes and only see what remains after they have been paid.
Exemptions for Inheritance Taxes
There are exemptions for the inheritance tax in the states where they are imposed. In all six states, the surviving spouse is exempt from paying the inheritance tax. New Jersey provides an exemption for all domestic partners.
The children and grandchildren aren’t exempt from the inheritance tax in Nebraska and Pennsylvania. In the other states, they don’t pay any inheritance tax.
Exemptions may be given to other relatives, such as siblings, and nieces and nephews for the inheritance tax. An exemption doesn’t mean they don’t pay any inheritance tax. It just gives them a lower rate based on their relation to the deceased.
Some states allow exemptions if the estate is worth less than a certain amount. For example, Maryland doesn’t require an inheritance tax if the estate is valued at less than $50,000.
These exemptions can change, which is why it’s important to seek legal counsel or talk to an accountant who specializes in inheritance taxes. You are responsible for paying the correct amount for the amount you receive in your inheritance.
How Much Do You Pay in Inheritance Tax?
The inheritance tax is based upon a percentage. These percentages range from zero all the way up to 18 percent. Each state sets its own rate, which it can change.
Iowa – 3-9 percent
Kentucky – 4-16 percent
Maryland – 10 percent
Nebraska – 1-18 percent
New Jersey – 11-16 percent
Pennsylvania – 0-15 percent
How is the Estate Tax Calculated?
The estate tax is also referred to as the death tax. It can be imposed at both the state and federal levels. Federal estate taxes can range from 18 percent to 40 percent. However, it only impacts an estate if it is worth more than $12.06 million. The exact rate will depend on the taxable amount of over $12.06 million. For instance, the estate would be taxed at 30 percent if the amount over the base amount was between $100,001 and $150,000.
The federal estate tax is assessed for the assets based on their current market value. The surviving spouse generally doesn’t have to pay an estate tax because they have an unlimited deduction.
Twelve states impose their own estate tax, which often has a lower threshold than the federal estate tax. The state tax varies by state. For instance, Hawaii imposes a tax for all estates over $5.49 million while Massachusetts has an exclusion of only $1 million.
How to Avoid Inheritance and Estate Taxes
Once a person dies and the estate is in probate, it’s too late to do anything about the taxes that are assessed. The best time to avoid taxes is with estate planning. You can put the estate in a trust, which can help protect it from certain types of taxes.
Another consideration is giving your inheritance away before you die. When given as a gift, the assets aren’t seen as an inheritance. They may be subject to other taxes or rules, which is why it is important to work with an experienced estate planning attorney.
You may want to spend your assets while you are still living or give them to a charity to avoid the inheritance tax. Charitable gifts are deducted from the estate.
Capital Gains Taxes
Another tax you may need to consider if you are receiving an inheritance is the capital gains tax. While not directly taxed on what you inherit, it comes into play if you report a profit from an inheritance. A prime example is if you inherit a house or other real property and sell it with a profit. The amount of profit you receive would be taxed at a higher rate as capital gains.
If the asset produces income, such as a business, it may have a capital gains tax imposed. You can pay either a long-term or short-term capital gain, depending on when you dispose of the property after the inheritance is received.
The value of the property is determined at the date of the person’s death regardless of how long ago they purchased it. This is beneficial to the heir because they will have a smaller gain if any.
An Example of When to Pay Capital Gains Tax
For example, a person bought a home 20 years ago at $200,000. It has now appreciated to $500,000 at the time of their death. If their heir sells the home a year later at $550,000, they only pay the capital gains tax on the $50,000 viewed as profit instead of the $350,000, which is the difference between the original purchase price and the price at sale. If you choose to sell right after receiving the property, you would owe no taxes because it would be sold at its current value.
Capital gains taxes can be complicated and often require the assistance of a professional to help you navigate these tricky waters. However, it is rare to owe a significant tax on inherited property that you choose to sell.
Federal and State Income Taxes on Inherited Property
For the most part, you don’t pay either federal income taxes or state income tax on the money you inherited from the decedent’s estate. This isn’t money you earned, so it’s not taxed as income.
The method of inheriting the asset doesn’t matter. For instance, you can inherit through a will or as a designated beneficiary from a trust. You can even be named as the beneficiary on a bank account or insurance policy and the money isn’t considered taxable income.
As you might expect, wherever there is a rule, there is also an exception. That exception is for retirement accounts.
Taxing Retirement Accounts
If you inherit a traditional retirement account, you will generally need to pay taxes on it when you withdraw any money from it. The account wasn’t taxed when the person set it up because it is deferred until funds are taken out. It is reported as regular income. You may be able to make regular withdrawals and only pay on the portion that you are taking out of the account.
Roth retirement plans don’t fall under the same rule. They have already been taxed when the person set up the account.
Other Income Tax on an Inheritance
Even though you don’t pay income tax on property you inherit, you do pay if it generates income. A prime example is keeping your family home and renting it out instead of selling the property. You must report the rent as earned income and pay taxes on it. If you inherit a bank account, you don’t pay income tax on the money. You will pay tax on any interest the account earns after you received it.
Life insurance is another tricky situation. If you get the proceeds in one lump sum, you won’t pay any income tax. If you receive the proceeds in installments with interest, you will pay taxes on the interest earned.
Receiving an inheritance can be complicated and subject to many different rules. Much of the time, you won’t pay taxes on what you receive, but there are numerous exceptions. You should speak with an experienced attorney or accountant to help you know when to report for taxes and how much you will be required to pay. They can answer the question, “Is inheritance taxable” in your case.