Table of Contents
Federal and state taxes on inheritance
Are there exemptions to the inheritance tax?
Inheritance tax vs. estate tax
How are different inherited assets taxed?
The bottom line
Aug 24, 2022
8 min read
Inheritance is due depending on the estate’s location and value at the time of the death. It is set at a threshold, taxes are due if an asset generates income or interest.
Receiving an inheritance can provide financial security or even a nest egg for retirement. But inherited money also comes with potential liabilities, sometimes in the form of taxes. Different taxes can apply depending on a variety of factors including the type of inherited asset, its location, and how the beneficiary uses the asset.
There are three scenarios where a beneficiary may be responsible for paying taxes. Firstly, an inheritance tax may be applicable if the deceased lived or owned property in one of six states. Secondly, a beneficiary may also owe taxes when interest or income is earned on an inheritance. And lastly, if an inheritance is sold, capital gains taxes may be due.
While there is no federal inheritance tax, there are some states that impose taxes when assets are transferred after death. This is called an inheritance tax. Six states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) have an inheritance tax that the beneficiary is responsible for paying. The inheritance tax applies if the decedent, or deceased, lived there or owned property in one of those states.
The beneficiary may have to pay taxes on part of the inheritance received, and the tax rate varies by state and relationship to the person that died. In some cases, there are exemptions to the inheritance tax for beneficiaries who are close family relatives, particularly spouses, or if the total estate value is below a certain threshold.
Besides taxes the beneficiary may be responsible for paying, taxes may be taken out of the estate before the beneficiary inherits anything if an estate tax is applicable. Twelve states and the District of Columbia impose an estate tax. There is also a federal estate tax for estates valued at more than $12.06 million for individuals in 2022; double that amount for couples.
The six states that impose an inheritance tax—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—provide exemptions to eliminate or reduce the tax liability based on a person’s relationship to the deceased and the estate’s value. Tax rates range from 1% to 18%.
The deceased person’s spouse is exempt from paying an inheritance tax in all six states. Children and grandchildren who inherit from family members in Pennsylvania and Nebraska may have to pay an inheritance tax, depending on the children’s age and the estate’s value.
In contrast, the other states extend the exemption to children and grandchildren. State tax laws provide the percentages that other family members and other beneficiaries will have to pay for the inheritance tax. Depending on the state, for non-relative beneficiaries, the inheritance tax ranges from 10% to 18%.
Some states do not levy the inheritance tax if the estate value is below a certain threshold. For example, there is no inheritance tax when inheriting assets from estates valued up to $25,000 in Iowa and $50,000 in Maryland.
An inheritance tax and estate tax can reduce the amount of assets beneficiaries receive. But in most instances, only one of these types of taxes will be owed. Maryland is currently the only state that imposes both types of taxes. There are distinguishing differences between an inheritance tax and an estate tax.
The estate pays the estate tax before the assets are distributed. Paying this is the responsibility of the executor, the person designated in a will or ordered by a court to be in charge of the estate, on behalf of the estate. For inheritance tax, the beneficiary pays the tax on the assets received.
The federal government does not impose an inheritance tax, but six states do depending on where the deceased lived or where they held property. The federal government through the IRS imposes an estate tax on all estates valued at more than $12.06 million in 2022. Although the federal estate tax may not apply in many instances, there may still be an estate tax since 12 states and the District of Columbia collect estate taxes.
After inheritance and estate taxes are paid (if applicable), there is the question of gains yield by inherited assets. While the value of inherited assets—including cash—generally doesn’t count as income to be taxed, interest or gains earned on the asset after it is inherited is usually taxable. For example, selling an inherited asset could trigger taxes on any gains, which are determined by subtracting the fair market value at the time of death from the sale price.
Generally, there are no taxes due on inherited cash or cash equivalents. It is not reportable income and is considered tax-free since, technically, the person already paid income taxes before death or the estate filed a final tax return before distributing assets. Cash equivalents include money orders, treasury bills, and some government bonds.
There is no difference if the money is found in a safe at the deceased’s home or in a bank account. However, a scenario where tax would be applied is when the inherited cash earns interest. Then, the earned interest counts as income on their tax return. Another example is when the beneficiary inherits cash in the form of a bonus, salary, or other taxable income from the decedent’s job that has not previously been claimed as income by the decedent or the estate. The heir would count this money as income on their tax return.
Inherited stocks themselves are not taxable, but taxes may apply in two scenarios: when the beneficiary receives dividends from held shares or capital gains from selling shares.
Any dividends the beneficiary receives from inherited stock are considered income and taxable.
If the beneficiary sells the stock at a profit, the gain is taxed. The stock is valued at fair market price at the time of the decedent’s death rather than the original purchase price. This is known as the step-up in basis. This can lessen the capital gains taxes due by using a higher fair market value instead of the price the decedent paid.
In most instances, if an individual decides to keep the inherited real estate or property, taxes may not apply. However, if the property produces income, such as is the case with a rental property, the resulting income would be taxed at the beneficiary’s ordinary income tax rate.
If the beneficiary sells the property, the money received from the sale could result in capital gains taxes.
The value of an inherited retirement account is not taxable. But, any withdrawals from a tax-deferred retirement account like a 401(k) or an individual retirement account (IRA) is considered taxable income. The beneficiary will owe ordinary income taxes based on their own income tax rate.
For accounts like a Roth IRA, required minimum distributions (RMD) may apply. Funded with after-tax money, withdrawals will not be considered taxable income if the account is more than five years old. The amount and frequency of the RMD varies based on the beneficiary’s relationship with the account holder and the date of the account holder’s death.
For other retirement accounts, withdrawals may be required depending on who inherits the account. A spouse can do a rollover to a retirement account of their own. Other beneficiaries can roll the funds into a particular type of account known as an “inherited IRA.” Still, the entire amount must be withdrawn in five to 10 years, depending on the type of account opened and the beneficiary’s relationship to the deceased.
An individual who inherits life insurance proceeds as a beneficiary would not have to pay income taxes on the money received since it is not considered income. If any interest is earned on the proceeds once deposited into a bank account, however, that interest would be considered income that is included on the beneficiary’s tax return.
Although most life insurance proceeds are distributed in lump sum, some policies may provide an option to receive the funds in installments. In that case, the proceeds may earn interest with the insurance company. Once distributed, the interest would be subject to income tax, but the proceeds would not.
Inheriting collectibles such as antiques, artwork, jewelry, stamp, or coin collections, for example, does not shield a person from paying taxes. Taxes are not due on the value of the items, but if collectibles are sold, then capital gains taxes are due. The beneficiary would be responsible for the capital gains taxes.
The tax rate for capital gains taxes when collectibles are sold can be as high as 28% if the collectible is held for more than one year. This is considered long-term gains. Collectibles sold within a year of the inheritance are considered short-term gains and are taxed at the beneficiary’s ordinary income tax rate. The step-up in basis value is used to determine the gains, which can decrease the amount of taxes due.
Federal and state inheritance or estate taxes may be due depending on the estate’s location and the estate’s value at the time of the person’s death. The federal estate tax is imposed at a certain threshold, and certain states may also levy their own estate tax that is paid before beneficiaries receive the assets. Beyond that, taxes are almost always due if an inherited asset generates income or interest, and if the sale of an inherited asset yields a capital gain.
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