Your Guide To Understanding Inheritance Tax

If you inherit assets from a loved one, you might be on the hook for a tax bill. While there are no federal tax requirements on inheritances imposed by the IRS, you might run into a state inheritance tax. Depending on your situation, this tax could put pressure on you to pay a large bill this tax year. With the right information on inheritance tax rules, you won’t be caught off guard.

How Inheritance Taxes Work

Inheritance tax rates vary based on three factors.

1.  The deceased person’s residence can affect the inheritance tax rate. This means that the state tax rules will greatly impact the amount you’ll pay with their unique tax rate.

2. The total value of the inheritance will have an obvious impact on the inheritance taxes paid.

3. Your relationship to the deceased will play a role. A more direct relationship to the deceased person will often lead to a lower tax rate. For example, a surviving spouse tends to pay less in taxes than a niece.

Once the inheritance tax is settled, you may face other taxes when selling the assets. If you decide to sell an asset that you inherited, then capital gains taxes could come into play. The recipient will be responsible for paying the inheritance tax on received assets and the capital gains tax on the amount of profits earned from the date of death, not when the assets were originally purchased.

Inheritance Tax Vs. Estate Tax: What’s The Difference?

You might hear the terms inheritance tax and estate tax used interchangeably. However, these two types of death taxes are separate things.

An estate tax is an amount taken out of someone’s estate after their death before anyone else receives funds. As of 2023, the federal government only imposes an estate tax when a deceased person’s assets exceed $12,920,000.

In contrast, an inheritance tax is due after the inheritor receives assets from the deceased. While there are no inheritance tax obligations at the federal level, several states levy an inheritance tax.

When it comes to inheritance taxes, different states have different rules. In some cases, inheritors may be able to avoid this tax if the assets they receive are valued under a predetermined threshold.

If you are the beneficiary of an estate, both estate taxes and inheritance taxes can have an impact on your bottom line. The federal estate tax can impact you if the deceased’s estate is worth more than $12,920,000. After the estate tax, inheritors can be on the hook for an inheritance tax in certain states.

How States Calculate Inheritance Taxes

While most states don’t charge an inheritance tax, some do. But the rules surrounding the inheritance taxes due vary from state to state. In general, the size of the inheritance and your relationship to the deceased will have an impact on how much you owe.

Many states have a threshold below which inheritors can enjoy a tax exemption. And some states allow tax exemptions for close relatives. For example, Kentucky allows surviving spouses, parents, children and immediate family to inherit without paying taxes. But nieces or nephews would face a tax between 4% – 16%. 

If you live in a state that levies inheritance taxes, it’s important to get familiar with the tax code or work with a professional to determine your tax liability.

How To Avoid Inheritance Tax

Inheritance tax is often an unwelcome financial burden. The good news is that residents in most states will find plenty of exemptions to lower inheritance tax liabilities. But if you want your heirs to avoid paying any inheritance taxes, planning ahead is essential.

One option is to buy a life insurance policy because the death benefit is usually not subject to inheritance taxes. Another option is to set up an irrevocable trust to hold the assets you wish to transfer to your heirs. Additionally, you could start making gifts to your heirs now, with the gift tax limit in mind.

As you consider your options, consider working with a tax law professional. With the right estate planning moves, your heirs can avoid a painful probate process and any unnecessary taxes.

Inheritance Tax FAQs

You have questions about inheritance tax. We have answers.

Which states have inheritance taxes?

Currently, six states impose an inheritance tax: Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania and Iowa. Because each state has slightly different rules surrounding their inheritance taxes, it’s important to seek guidance from an expert in your home state.

How much can I inherit without paying taxes?

At the federal level, estate taxes are only required if the deceased left behind more than $12,920,000. But some states impose an inheritance tax on amounts below that IRS threshold. The amount you can inherit without paying taxes varies by state. In some cases, you’ll pay taxes on any amount of money you inherit.

Do beneficiaries pay taxes on inherited money?

Beneficiaries who inherit money may have to pay taxes on those funds. Whether you owe taxes on the funds will vary based on the state you live in.

Do I have to report inheritance money to the IRS?

In general, the IRS doesn’t consider inheritances to be taxable income. With that, you may not need to report your inheritance to the IRS. However, if you sell the assets, that might create taxable income. If in doubt, it’s always a good idea to consult a tax professional.

Who has to pay inheritance taxes?

An inheritance tax is levied from the person who inherits the assets. If you have inherited assets, some states will determine that you owe taxes on those funds.

What states have an inheritance tax?

Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania, and Iowa each impose inheritance taxes on their residents. If you or the deceased lived in one of those states, you may owe taxes on the inherited assets.

Is inheritance considered income?

An inheritance is generally not considered taxable income by the IRS. But it gets complicated if you sell the assets. When you sell an inherited asset, you may create taxable income. Additionally, any earnings from inherited assets are considered taxable income.

The Bottom Line: Few States Have Inheritance Taxes

If you live in a state with inheritance taxes, you may get a tax bill. But in most parts of the country, inheritance taxes won’t take a bite out of your inheritance.

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