It’s never pleasant to think about the death of a loved one, but if there is the possibility that you will receive an inheritance, you may have to pay taxes on it. Of course, the last thing you want to think about when going through a loss is the tax consequences of an inheritance, but if you have to pay them, it’s best to know what to expect, right?
Unfortunately, taxes on an inheritance can be quite complicated. Each state is different and may require you to pay an inheritance tax. Also, there are other taxes you may need to pay, depending on what you inherit and how much the value of the assets you received is.
So, how is the tax on inheritances calculated, and what do you need to pay to whom? All of this may sound quite confusing right now, but don’t worry; we’ll cover this topic in detail, so you can understand what kind of taxes you may be facing with an inheritance.
What Taxes You May Need to Pay with an Inheritance
What taxes do you need to pay? Why are there multiple types of taxes for an inheritance? Well, the answer may be somewhat confusing because there are different types of taxes you need to pay with an inheritance. There are actually at least three taxes that you may have to pay.
The first tax you may have to pay is the actual inheritance tax. The good news is that the federal government does not require you to pay this tax, but your state may. We will cover which states have an inheritance tax in detail. If you do fall under one of the states that requires you to pay an inheritance tax, there are specific limitations on how much of your inheritance is subject to tax.
The second tax you may have to pay is an estate tax. The federal government does require you to pay an estate tax if the value of the assets you have inherited is above a certain amount. We’ll go over this amount in this article, so you are aware of what you need to report and pay to the federal government (the IRS).
The third tax you may have to pay is called a capital gains tax. This tax is only applicable if you inherit a capital asset. A capital asset is a significant piece of property like a house, jewelry, fine art, antiques, or collectibles. We’ll look at each one of these types of taxes in more detail.
Inheritance vs. Estate Taxes
An inheritance tax is the state tax you may have to pay when you receive assets from the estate of a deceased person. This tax is only relevant if you live in one of the six states that has an inheritance tax. You must also have inherited over a specific amount before this tax is applicable. For these reasons, not a lot of people have to pay an inheritance tax.
According to the Tax Policy Center, an inheritance tax may come in three principal forms.
- An annual accessions tax applies to gifts and bequests that a person receives in the year.
- An inclusion tax considers gifts and bequests to be income; thus, they are taxed that way.
- A lifetime accessions tax applies to gifts and bequests received over the course of a lifetime.
These tax rates depend on the size of the inheritance, as well as the beneficiary’s other income. An inclusion tax may be combined with one of the other two taxes into a single tax, which takes advantage of the strengths of each.
An estate tax is a tax on the value of a deceased person’s assets. It is enforceable by the federal government, not the state. This tax is only applicable if you receive more than the annual threshold amount. Again, the majority of people do not inherit assets above the threshold, so not that many people must pay this tax.
The Difference Between Inheritance and Estate Taxes
An estate tax is imposed on the estate left by the deceased person, not on the individual amounts left to beneficiaries; an inheritance tax may be imposed on the individual beneficiary based on the amount he or she inherits. Estate taxes are imposed by the federal government, whereas inheritance taxes are imposed by the state government.
Who Has to Pay the Inheritance Tax?
Federally, you will not have to pay any inheritance tax, but each state is different. Currently, there are only 6 states in the United States that require you to pay an inheritance tax. The following states impose this tax:
- New Jersey
Who Has to Pay the Estate Tax?
According to the IRS (Internal Revenue Service), the federal estate tax only applies to estates with values exceeding $11.4 million in 2019 and $11.58 million in 2020. Surviving spouses are not required to pay estate taxes.
Let’s look at some facts!
According to the Tax Policy Center, the top 10% of income earners pay more than 90% of the estate taxes in the United States, with nearly 40% paid by the richest 0.1% of Americans.
The Tax Policy Center further reports the following:
“The estimated number of total and taxable estate tax returns is 4,100 and 1,900 for both 2019 and 2020. Estimated estate tax liability is $15.6 billion in 2019 and 16.0 billion in 2020.”
How Much You May Need to Pay
The tax levied by the state in regards to your inheritance can be as low as 1% or as high as 20% of the value of assets you have inherited. Each state is different. Typically, the highest percentage tax rates apply to the largest inheritances.
Examples of the thresholds for these states include:
- In Iowa, if you inherit less than $25,000, you will not need to pay the inheritance tax.
- In Maryland, the same holds true, but the threshold is $50,000.
The tax levied by the federal government is the estate tax, and you only have to pay it if the estate is valued at over $11.4 million in 2019 and $11.58 million in 2020.
How Inheritances Usually Work
Typically, assets are divided and distributed by the executor of the estate. They are handed out to beneficiaries, who must then pay inheritance tax on assets he or she receives. Remember, though, not all states require you to pay inheritance tax.
Because the threshold in which you have to pay federal estate taxes is so high, less than 2% of Americans have to worry about paying federal estate taxes or inheritance taxes. In other words, you probably will not have to pay any type of inheritance tax unless you receive a very large inheritance.
How to Calculate Your State Inheritance Tax
If your state requires you to pay an inheritance tax, you will need to take the total amount you inherited, but only the amount over your state’s threshold, and multiply it by the percentage of inheritance tax your state has implemented for beneficiaries. Sound confusing? Don’t worry! We’ll go over a couple of examples.
Your state has a 5% inheritance tax for any beneficiary receiving assets valuing over $1 million. You have inherited $3 million from a relative. You will only have to pay taxes on the $2 million ($3 million you inherited less the $1 million threshold decided by your state). You are required to report $100,000 ($2 million multiplied by your state’s 5% tax) on an inheritance tax form.
Your state has a 10% inheritance tax for any beneficiary receiving assets valuing over $500,000. You have inherited $1 million from a deceased spouse. You will only have to pay taxes on the $500,000 ($1 million you inherited less the $500,000 threshold decided by your state). You are required to report $50,000 ($500,000 multiplied by your state’s 10% tax) on an inheritance tax form.
How to Calculate the Federal Estate Tax
To determine the estate tax you owe, use the following table. These figures have been adjusted to reflect the most recent updates for the 2020 tax year. Keep in mind for the tax year 2020, you only need to pay the federal estate tax on estates with values exceeding $11.58 million.
Trusts and Estates
If taxable income is between…
The tax due is…
$0 to $2,600
10% of taxable income
$2,601 to $9,450
$260 + 24% of the amount over $2,600
$9,451 to $12,950
$1,904 + 35% of the amount over $9,450
$3,129 + 37% of the amount over $12,950
Let’s look at an example of how to calculate the estate tax you may owe.
Your taxable income in 2020 is $2,000, and you inherit an estate worth $15 million. You will need to pay $200 (10% of your taxable income of $2,000).
What is Capital Gains Tax?
A capital gains tax may apply if you inherit a capital asset, like an investment, such as real estate. A capital gain is realized when a profit is realized from the sale of a capital asset. So, if you inherit a capital asset worth $100,000 and sell it for $300,000 years later, you may owe capital gains tax on the $200,000 capital gain.
For more information on capital gains tax, check out How to Make Capital Gains Taxes Work for You. With a capital asset, you may not have the original purchase price since you inherited it. For this reason, you must use a basis other than its cost. To understand this better, see IRS Publication 551: Basis of Assets.
Tax Exemptions on Your Inheritance
Depending on the state you live in, the amount of inheritance you receive, and/or your relationship with the deceased person, you may be able to receive an exemption or possibly a reduction in the amount of inheritance tax you will need to pay. Let’s go over a few of the tax exemptions on amounts inherited.
Surviving spouses are exempt from inheritance tax in the United States. Domestic partners are also exempt in the state of New Jersey. Descendants pay no inheritance tax except in Nebraska and Pennsylvania. Typically, the most unrelated individual to the deceased person pays the highest rate of inheritance tax.
Life insurance payable to a named beneficiary is usually not subject to an inheritance tax. However, life insurance payable to a deceased person’s estate is often subject to an estate tax.
Keep in mind that tax laws change all the time. If you have received an inheritance, be sure to check with your state’s tax agency, so you will know the latest laws and rules in relation to inheritance or estate tax. The IRS has a page devoted to state government websites; you may be able to find the current tax information there. Just look for your state and click on the link.
Investopedia lists further information about the state exemptions in detail regarding inheritance tax.
How to Reduce Tax on Your Inheritance
# 1 Set up a trust for the assets you have inherited.
A trust is a way for you to pass on your assets to your chosen beneficiaries after your death without having to go through probate. Trusts are like wills, but they generally avoid state probate requirements and most associated expenses.
The Benefits of Setting Up a Trust
There are many benefits to leaving your assets to your descendants in an inheritance trust. First, the trust can be set up to only go to your child, not their spouse. Second, the assets are protected from any creditors in the event of financial hardship. Finally, upon the death of your children, any unused assets go directly to blood relatives.
Market Business News lists several more reasons it is beneficial to set up a trust for your loved ones. As mentioned before, it helps protect and control your family’s assets. It’s a helpful tool when the beneficiary is not old enough to handle his or her inheritance. Also, it can be a handy tool when the beneficiary is incapacitated and cannot handle his or her affairs.
A trust is a solid way to pass along assets while you are still alive. It can also prove to protect against certain property claims and against beneficiaries who are poor with money. Another benefit of a trust is that it offers you flexibility if changes in the law occur, and let’s face it; changes in the law are inevitable.
That’s why hiring a specialized lawyer to help you with your affairs is a wise thing to do. Trusts are complicated contracts, and you can greatly benefit from their knowledge, experience, and expertise.
#2 Make gifts of your inheritance while you are alive.
You may wish to donate some of your inheritance to the less fortunate. This is a rewarding way to spend your gains. Plus, you may be able to deduct charitable contributions on your annual tax return.
Another option is to give gifts to your loved ones while you are alive. You can give them annual deposits to spend as they see fit. The annual exclusion amount for the 2019 and 2020 tax years for gifts is $15,000. This means you can give as gifts up to $15,000 without it being subject to gift taxes.
Giving gifts can be advantageous and disadvantageous. Giving them annual gifts under the gift tax threshold can reduce the amount of taxes they will need to pay on their inheritance.
However, if you are careful and particular about your money, you may not want to see how your loved ones spend the money you give them as gifts. Often, parents don’t approve of the children’s spending habits.
#3 Minimize your retirement account distributions.
Retirement accounts are not subject to taxes until you begin receiving distributions. If you can hold off on taking out distributions, which you are not required to do until age 72, you can save money on the tax your loved ones have to pay when you pass away.
There are more guidelines and benefits to minimizing your retirement account distributions.
Most taxpayers do not have to pay taxes on their inheritance, because the thresholds are so large. If you live in one of the states that imposes inheritance taxes, you may have to pay the tax. How much you have to pay may depend on how close you are to the deceased and how much you inherited.
You may also have to pay estate taxes at the federal level if your inheritance is more than $11.58 million. Generally, the closer your relationship to the deceased, the higher the exemption, and the lower the rate you’ll pay.
Do you need help with estate planning? Worried about leaving your descendants with too much inheritance or estate tax? We can help you with your estate or income taxes.
We are knowledgeable about how the tax system works and how to properly prepare tax returns. We can even represent you in the event of an audit. Get the help you need today; you can trust Indiana’s tax expert!