Do You Have to Pay Taxes on Inheritance? [Full Guide]

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When faced with the death of a loved one we might not have much interest in inheritance-related issues, however, there are some financial practices that all should be aware of.

One question that confuses many is “do you have to pay taxes on an inheritance?” This depends on a few factors, including which state you reside in and how the inheritance is distributed.

In this article, we will discuss:

  • what states tax inheritance
  • how the tax works
  • how you can avoid paying it

What Are Inheritance Taxes?

The taxes that are levied on the transfer of property from a deceased person to their heirs are known as inheritance taxes. They are based on the value of the property that is being inherited and are typically paid by the executor of the estate.

In most states, these taxes are due at the time of the deceased person’s death, but some states have a delayed payment option.

DID YOU KNOW: The most recent 2019 Survey of Consumer Finances (SCF) found that the middle-class average inheritance in the US was around $110,000.

How Does Inheritance Tax Work?

Taxes are complicated and not everyone can understand the way they work. What makes inheritance taxes a bit less complicated is that there is no federal inheritance tax. Only six states, which we’ll list below, require a tax on inherited assets. The way that the tax is calculated depends on the state in which you reside.

In most, it represents a percentage of the value of the property being inherited. This percentage can range from 0% to 18%, and there may be different rates for different types of property.

DID YOU KNOW: The only state that charges both inheritance and estate taxes is Maryland. This state also has the lowest inheritance rate (10%), and all direct lineal heirs are entitled to tax relief on their inherited assets. 

Who Pays Inheritance Taxes?

Unlike estate taxes which are paid from the deceased person’s estate, inheritance taxes are paid by the beneficiary who receives the assets.

Whether or not a beneficiary will pay tax on the assets depends on whether the decedent lived in one of the six states that have this type of tax.

Tax rates also depend on the beneficiary’s relationship with the deceased. Spouses, for example, are always exempt from paying taxes. Immediate relatives, such as children, are also often exempt or pay some of the lowest tax rates on inheritance. Beneficiaries who are non-relatives end up paying the highest tax rates.

DID YOU KNOW: Inherited stocks are not taxed. Upon the death of the giver, taxes are taken out of his or her estate. Beneficiaries are liable to end up paying taxes on stock inheritance only if they decide to sell. 

Key Takeaways

Although there is no federal tax on it, inheritance is taxable in 6 states within the US.
The tax in these states ranges from 0% to 18%.
The beneficiary who receives the inheritance has to pay the tax.
Spouses are exempt from inheritance taxation while children can be exempt or pay a minimal amount. 

How Much is Inheritance Tax?

The amount of inheritance tax that you will have to pay depends on:

  • the state in which you reside
  • the size of the inheritance
  • your relationship with the deceased

Generally, the tax is a percentage of the value of the property being inherited. The percentage can range from 0% to 18%, and there may be different rates for different types of property. You can find out more about the different tax rates with a free tax consultation.

DID YOU KNOW: According to a 2021 OECD report, which includes 37 countries, only 24 countries around the world levy inheritance or estate taxation, and only 0.5% of the total tax revenue comes from an estate, inheritance, or gift taxes. 

What States Have Inheritance Taxes?

As of 2021, the six states that charge taxes on inheritance are:

  • Iowa (0-15%)
  • Kentucky (0-16%)
  • Maryland (0-10%)
  • Nebraska (1-18%)
  • New Jersey (0-16%)
  • Pennsylvania (0-15%)
DID YOU KNOW: In 2021, Iowa made a decision to repeal such a tax. These taxes are likely to decrease by 20% during the period between 2021 and 2024 and no longer be in force by 2025.

When Do You Have to Pay Inheritance Taxes?

In most states, this tax is due at the time of the deceased person’s death.

However, some states have a delayed payment option. In these states, you may be able to pay the tax over a period of time.

DID YOU KNOW: Research shows that within the next 25 years Baby Boomers are expected to pass on nearly $68 trillion worth of assets to younger generations.

Do You Pay Taxes on a Trust Inheritance?

By setting up a trust an individual can make sure that his or her assets are properly distributed and avoid paying a tax on inheritance. 

There are various types of trusts that a person can establish but they fall under two general categories: a revocable and irrevocable trust. The former can be altered during the grantor’s lifetime while the latter is fixed and can be closed only upon the trust maker’s death.

Whether you pay taxes on trust inheritance depends on the type of the fund. Revocable trusts will are taxed, while irrevocable trusts aren’t and can help you prevent incurring the tax.

DID YOU KNOW: Unlike wills, when set up properly trusts do not have to go through probate. Probates are often very lengthy and can take a couple of years to complete; heirs cannot take their share until the estate is settled. 

How to Invest Inheritance Money to Save It from Taxes?

So, how do you invest your money to save it from state inheritance taxes? The best way to invest an inheritance will vary depending on individual circumstances. Read on to find the one that fits your financial situation best.

There are a number of tax breaks that you can take advantage of when you inherit money. These include the step-up in basis, the capital gains exclusion, and the charitable donation deduction. 

Step-up in Basis

The IRS has a different approach toward inherited assets. The step-up in basis greatly benefits heirs as it charges beneficiaries only on the capital gains they make when they sell the inherited assets.

For example, usually, children receive an inheritance from parents in the form of property. If your parents purchased a house worth $5,000, let’s say now it is worth $8,000. To determine the income tax on inheritance and how much you owe in capital gains you need to know your basis. The step-up in the basis set the cost of your inheritance according to its current market value.

If the inheritor decides to sell immediately, he or she would not owe any capital gains. If you hold on to the property for a few years and it gains in value and is now worth $9,000, according to the step-up in basis you will only be charged $1,000. This sum is the difference between the $8,000 and the selling price.

Using the step-up in basis will not allow you to fully avoid taxes but it will lessen them.

Charitable Donation Deduction

If you donate an inherited asset to a charity, you may be able to get a deduction for the value of the asset. But before you donate in an effort to reduce taxes on inheritance, you must make sure that the charity of your choice is on the IRS qualified charities list.

Keep Fees Low

When you inherit money, there are a number of fees that you will have to pay. These include the attorney’s fees, the executor’s fees, and the taxes. To keep these costs low, try to use an attorney who does not charge by the hour and find an executor who is willing to work for a percentage of the estate.

Put Your Kids Through College

It is a good idea to invest the money you inherited from a loved one into your kids’ college fund. For example, you could invest in the future of your children by using the money to set up an Education Savings Account or add to an existing one.

Pay Off Debt

Taking care of accumulated debt while also lessening your taxes on inheritance money will certainly help you sleep soundly. Using the money to pay off your credit card bills will surely lessen your load, but it will not stop you from spending again. Financial experts advise that paying off debt is only a good idea if the interest rate is lower than what you might get in a low-fee stock. 

Pay Down Your Mortgage

Take your circumstances into consideration before making the decision to invest your inheritance into paying off your mortgage. Many Americans choose to use their inheritance to pay off the mortgage simply to free themselves from the monthly payments during retirement.

DID YOU KNOW: In 2021, President Biden issued a proposal to eliminate the step-up in basis. This will likely lead to bigger estate inheritance taxes as the step-up in basis is a tool meant to lessen such taxes. 

How to Avoid Inheritance Taxes?

There are a number of ways that you can avoid taxes that come with inheriting assets.

Keep Below the Threshold

The best way to keep below the tax threshold is to give money away during your lifetime. You can do this through a trust or by making direct gifts to your heirs.

Put Assets Into a Trust

Another way to avoid taxes on inheritance money is to put the assets into a trust. If you do this, the trust will be the owner of the assets and not you. This means that when you die, the trust will be the official owner of the assets, benefiting your heirs.

Traditional and Roth IRA

Individuals are not subject to tax on the money within the inherited IRA, however, they will be taxed upon making distributions from the traditional IRA. The tax on withdrawals is the same as the original owner’s. Roth IRAs on the other hand are usually tax-free but you must delete the account within the next five years.

Irrevocable Trusts

Unlike the revocable living trust which can be altered at any time by its grantor, with an irrevocable trust account the grantor puts all assets in the hands of the trustee.

Such trusts are considered accidental loopholes as they are used largely for transferring assets to beneficiaries without paying gift or state inheritance taxes. As the grantor gives up ownership of the assets they are no longer part of his or her estate and will not be subjected to estate tax when the grantor dies.

Different types of assets such as life insurance policies, cash, and investment assets can be put into trust.

Give Away Your Assets

Each individual is entitled to a one gift allowance per year or annual exemption. The annual exemption limit for 2022 is $16,000.This means that there is no tax on gifts that do not exceed this amount. This gift-tax limit does not refer to the total amount you can give within a year; you can give as much as $16,000 to one person. This might not help you avoid inheritance taxes but it will lessen your estate taxes.

The Lifetime Gift Tax Exemption

The IRS allows taxpayers to give as much as $12.06 million during their lifetime. This means that most Americans will not be able to exceed this limit during their lifetime and can freely give away from their estate. However, you still need to include a larger gift than $16,000 in your tax reports. Many prefer hiring someone to do their taxes for them, but learning to do your taxes by yourself can be very cost-efficient.

Life Insurance Policy

Life insurance is a great way to pass on larger sums of money to your heirs as the proceeds of income tax are free. On the downside, they might be included as part of the taxable estate and subject to estate tax purposes. However, to avoid federal taxes on inheritance, you can simply transfer the ownership of your life insurance to your spouse or children. This process is irrevocable and the new owner of the policy must pay premiums but they can be settled in the form of gift allowances.

Move to a Different State

This might be the easiest way to settle the inheritance taxation problems but it is effective. You can limit the government’s access to your wealth by moving to a state with no inheritance or estate taxation. In terms of taxation, the residence of the deceased person is taken into account not the residence of the recipient.

DID YOU KNOW: In the majority of states, federal taxes on inheritance apply above a certain amount. Inheritances below the given tax threshold are exempt from tax. Tax laws in Maryland require no tax on estates valued below $50,000, while in Iowa the tax threshold limit is $25,000. 

Do You Have to Pay Taxes on Inheritance: In Conclusion

Generally speaking, inheritances are not income for federal tax purposes. However, there are a few states that impose taxes on them, so it is important to know what your tax responsibilities are. Luckily, there are a number of ways that you can avoid inheritance taxes, including giving money away during your lifetime, putting assets into a trust, and taking out a life insurance policy. By using these and similar strategies, you can keep your tax bills to a minimum.

FAQ

Do I have to report inheritance on my taxes?

Though usually, inheritance is not part of your tax report there are some exceptions. Beneficiaries have to report subsequent earnings from selling the inheritance, for example.

Do beneficiaries pay taxes on their inheritance?

Do you have to pay taxes on inheritance everywhere across the US? Luckily no, tax is only paid in six states that impose inheritance taxation and the amount ranges between 0% and 18%.

Which states have no estate or inheritance tax?

In 2022, 33 states impose neither inheritance nor estate taxes: Alabama, Alaska, Arizona, Arkansas, California, Colorado, Delaware, Florida, Georgia, Idaho, Indiana, Kansas, Louisiana, Michigan, Mississippi, Missouri, Montana, Nevada, New Hampshire, New Mexico, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia, West Virginia, Wisconsin, and Wyoming.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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