When the time comes that a loved one passes away, you might receive an inheritance of some kind. While the assets you receive do stand to assist you, financially speaking, you might also need to handle a few further financial matters related to your inheritance to ensure you comply with state laws. Often, inheritances are taxable. But whether you need to pay taxes — and the amount you could end up paying — are based on a variety of different factors.
The deceased’s state of residence, your relationship to them and the amount you’re inheriting can all play a role in determining the taxes you may need to pay. Some beneficiaries of inheritances don’t owe anything, while others need to pay a large percentage of the total value of the inheritance to the government. If you’ve recently inherited assets or stand to in the future, take a look at the details you need to know to determine whether your inherited funds are taxable — and to better prepare for the future.
Taxes on inheritances are complex. Some people have to pay them and some don’t. In general, the government taxes a deceased person’s assets in two separate ways: inheritance taxes and estate taxes. Beneficiaries — the people who receive inheritances — pay inheritance taxes directly to their state. Estate taxes are dealt with before the inheritance reaches them.
To determine whether or not you’ll pay an inheritance tax, several factors come into play. Inheritance taxes only exist on the state level, not at the federal level, and states determine their own inheritance tax rates and exemptions. Out of all the U.S. states, only these six levy an inheritance tax:
- New Jersey
If your deceased loved one lived in any of these states, an inheritance tax could apply. If you’re a beneficiary who lives in one of these states but the deceased did not, inheritance tax doesn’t apply as of 2022 — taxation depends on the deceased’s state of residence, not yours. Keep in mind that state laws regarding inheritance taxes can change at any time, however, so it’s best to check the most updated tax regulations in your state.
There is a third way that an inheritance may be taxed, though it’s less direct. These taxes arrive through state and federal income taxes. The federal government doesn’t generally consider inheritance as income, though it treats different types of inherited assets differently depending on a beneficiary’s actions surrounding them.
For instance, inherited money or property isn’t taxable as income, but any gains that come from selling inherited property are usually taxed. Additionally, distributions withdrawn from an inherited retirement account may be subject to taxes.
Inheritance Tax Is Different From Estate Tax
Despite the fact that inheritance taxes and estate taxes are types of taxes levied on a deceased person’s assets, they work differently. Estate taxes are paid for before the inheritance even reaches its beneficiaries. That’s because they’re subtracted from the deceased’s assets before the inheritances are distributed. Beneficiaries are responsible for paying inheritance taxes after the inheritance is distributed and they’ve received the assets. Sometimes, however, the deceased may include provisions in their will to pay inheritance taxes so beneficiaries don’t have to.
Furthermore, estate taxes can come from both the federal and state levels, whereas inheritance taxes are levied only by certain states. Federal estate taxes don’t apply to many people; they’re only charged on estates with a value of $12 million or more (in 2022). Not all states charge estate taxes, and, interestingly, Maryland is the only state that collects both inheritance and estate taxes.
Who Is Exempt From Inheritance Tax?
Different taxation rules apply to individual beneficiaries depending on the amount they’ve received as well as their relationship to the person who passed away. Different states determine who needs to pay inheritance taxes based on their relationship to the deceased. States can also set separate inheritance tax rates that vary based on the amount inherited.
For example, in all six states that levy inheritance taxes, spouses are exempt from paying. New Jersey even exempts domestic partners from paying the inheritance tax. Nebraska and Pennsylvania are the only states that don’t exempt the deceased’s children and grandchildren from paying.
The amounts other beneficiaries pay in inheritance tax vary by state. Related parties, such as siblings, nieces, nephews, aunts, uncles and step-children, typically pay less than beneficiaries outside of the family, if they pay anything at all.
Inheritance tax rates also depend on the amount inherited. Some states allow for monetary exemptions. One example of this is in Iowa, where an inheritance with a value of $25,000 or less isn’t taxable. As mentioned, inheritance tax rates vary from state to state. States base their rates and exemptions on not only beneficiaries’ relationship to the deceased, but also the amounts those beneficiaries receive. In the six states that collect inheritance taxes, beneficiaries pay between 0% and 18% of the inheritance’s total value.