If you anticipate receiving or recently inherited assets, you may be concerned with the possible tax implications. A lesser-known tax that you may be subject to is an inheritance tax.
Tax laws can be complex and vary by state, so figuring out if you’re subject to inheritance tax and what that might be can be complicated.
Inheritance tax is applied to financial gains received via inheritance. This is not a typical tax like income tax and only applies in six US states. Inheritance tax is different from estate tax as it is paid by the person inheriting the assets.
This article will take a deep dive into inheritance tax. You will learn what it is, how it works, and what states you can find his uncommon tax in. This article will also provide brief summaries of other taxes that you may encounter when you receive an inheritance.
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What is an Inheritance Tax?
An inheritance tax is a tax that is implanted when an individual inherits assets. The recipient is responsible for paying the tax. Therefore, it is essential to know if the inheritance tax applies to you and your situation.
Inheritance tax is not applied until the inheritance has been disbursed. The inheritance tax is not a flat rate tax nor is it your standard income tax rate.
There are actually three components used to determine if an inheritance tax rate will be, if any at all. These components are:
- The state where the deceased person lived or owned the property.
- The value of the inheritance.
- The recipient’s relationship to the deceased person.
Inheritance Tax Rates
Inheritance tax does not apply to the total value of the inherited assets. There is an exemption amount. Over the exemption amount, the tax can reach up to 18%.
The specific tax rate varies based largely on the relationship between the deceased and the recipient and partially based on the value of the assets.
Minimizing or Avoiding Inheritance Tax
The amount of the inheritance tax can be reduced or avoided altogether in some cases. As mentioned above, three criteria are used to determine the inheritance tax.
Tips to minimize or avoid inheritance tax:
- Name recipients in irrevocable trusts, living wills, or insurance policies rather than bequeath money.
- Provide money to recipients’ over a lifetime instead of a lump sum.
- Keep in mind that closer relatives that receive smaller amounts may be exempted.
- Gift loved ones while you are still alive. The federal government allows gifts up to $15,0000 in value with no gift tax exemption
- Surviving spouses are automatically exempted, and in New Jersey only, domestic partners are also exempted.
- Descendants are also exempted in Iowa, Kentucky, Maryland, and New Jersey.
If you are in a state that has an inheritance tax and you desire to minimize or avoid it, it is recommended that you meet with a qualified tax expert.
A tax expert can assist with developing and implementing estate planning.
Which States Have Inheritance Tax?
Fortunately, inheritance tax does not exist at the federal level. Further, it is only imposed in a handful of states. As of 2022, there are only six states that implement an inheritance tax.
These six states that have an inheritance tax are:
- New Jersey
Iowa inheritance tax rules
Iowa automatically waives the inheritance tax when the value of the estate is $25,000 or less. There are also exemptions for immediate family, including:
Iowa allows a maximum of $500 for assets given to charities. It should be noted that Iowa is in the process of eliminating the inheritance tax.
A bill was passed in 2021 to begin the process. Inheritance tax will not be imposed on inheritances of deaths that occur after January 1, 2025.
Kentucky inheritance tax rules
Like Iowa, Kentucky grants exemptions to immediate family members. Those outside of the immediate family will be exempt up to $1000, depending upon the value of the assets.
Kentucky is unique in that it imposes a tax rate of 4% up to 16% for inheritances over $1,000, based on the amount of the inheritance. Additionally, there is also a flat dollar tax.
Maryland inheritance tax rules
Maryland excludes all estates valued at $50,000 or less from the inheritance tax. It should also be noted that Maryland has both inheritance tax and estate tax (discussed further below), and due to this, one inheritance may be taxed up to three times.
Immediate family are exempt, including:
Charities are also exempt. Recipients other than immediate family and charities are exempt for up to $1,000. Beyond the $1,000 threshold, the inheritance tax rate is 10%.
Nebraska inheritance tax rules
Nebraska’s inheritance tax guidelines are more complex than the other states. It is also important to note that Nebraska currently has the highest tax rate of all six states that impose an inheritance, but reductions in inheritance taxes will begin in 2023.
In this state, only spouses and charities are exempt. Children, grandchildren, parents, grandparents, and siblings are exempt up to $40,000 and taxed at 1% beyond that.
Non-immediate family members are exempt up to only $15,000, and the tax rate for this group jumps up to 13%. Finally, intended recipients who are unrelated are exempt up to $10,000 with a tax rate of 18% over that threshold.
New Jersey inheritance tax rules
New Jersey excludes immediate family and charities from the inheritance tax. Siblings, sons-in-law, and daughters-in-law are exempt for up to $25,000.
Beyond that, the standard inheritance tax in New Jersey is 11%.
Pennsylvania inheritance tax rules
Pennsylvania allows exemptions for spouses and children ages 21 and younger. The maximum exemption amount for adult children, parents, and grandparents is $3,500.
Pennsylvania also has farmland and agricultural property exemptions. Pennsylvania has three tax rates:
Adult children would fall into the 4.5% tax rate category. Siblings of the deceased would have a 12% tax rate, and finally, any other inheritors would be taxed at the 15% rate.
When to Pay Your Inheritance Tax
If it is determined that you owe an inheritance tax, your next question will likely be: when is it due? Because inheritance tax is a state tax, the rules may vary by state.
In Iowa, Kentucky, Maryland, and Pennsylvania, for instance, the inheritance tax must be paid within nine months of the death. Both Kentucky and Pennsylvania provide a 5% discount if the inheritance tax is paid within nine months.
In special cases, Kentucky allows for ten equal installment payments. In New Jersey, you have slightly less time to pay the inheritance tax: eight months.
In Nebraska, the inheritance tax is paid to the county rather than the state, so payment times will depend on where you live.
Inheritance Tax vs. Estate Tax
Inheritance tax should not be confused with the estate tax. These two types of taxes have two key differences. An estate tax is similar to an inheritance tax in that they are both imposed when a deceased person leaves assets to another person or persons.
In other words, both inheritance tax and estate tax are “death taxes.” An estate tax is a tax placed on the value of an estate prior to the distribution of assets.
The tax is paid by the deceased individual’s estate. An inheritance tax, on the other hand, is paid by the recipient or inheritor. Another key difference between the two is that the inheritance tax is only imposed by the state.
The estate tax can be imposed by the federal government, particularly if the estate is large. There is no federal inheritance tax.
Federal Estate Tax
The federal estate tax is only implemented when the estate is sizable. For the 2022 tax year, estates $12.06 million or more are subject to the estate tax.
The tax rate for the federal estate tax ranges from 18% to 40%. However, given the $12.06 million threshold, it is estimated that only 2% of taxpayers are subjected to the federal estate tax
In some instances, an individual may find themselves subjected to an inheritance and estate tax for an inheritance, although this is not a common scenario.
It occurs when the deceased resided in a state with an inheritance tax, and the inheritance is not fully exempt.
State Estate Tax
Estate taxes also exist at the state level. Like inheritance tax, not all states have an estate tax. Twelve states plus Washington DC have estate taxes.
The twelve states that impose an estate tax are:
- New York
- Rhode Island
Fortunately, state estate taxes have a fairly significant threshold, though not quite as high as the federal. This means that while your inheritance may be small enough to circumvent the federal estate tax, you may face state estate tax if you live in the twelve states listed above or Washington D.C.
The states with the lowest exemptions are Massachusetts and Oregon at $1 million. On the other end of the spectrum, New York’s threshold is the highest at $6.1 million, with Maine following behind at $5.8 million.
Other Possible Taxes
Unfortunately, your inheritance may be subject to more than inheritance and state taxes. It is possible that you may encounter other taxes, specifically capital gains tax and taxable income.
Capital Gains Tax
If you receive an inheritance and later sell the assets, you may be subject to capital gains tax. Capital gains taxes are reserved for the following:
- Stocks and bonds.
- Coin collections.
- Real estate.
Simply put, capital gains tax is a tax on the profit received from the sale of an asset. Thus, if you sell an inherited asset at a profit, you can be taxed on that profit.
Capital gains tax is owed the year that the asset is sold. The rates range from as little as 0% to 20% for long-term capital gains tax.
If the asset was only in your possession for a year or less, you will be subjected to the short-term capital gains tax. Short-term capital gains tax is taxed at your normal income tax rate.
Sometimes, it is the type of inheritance you receive that may lend itself to additional taxation. A prime example is an inheritance of an IRA or 401(k).
In these cases, any distributions you receive from these accounts could potentially be taxable.
Inheriting a 401(k)
As long as the funds remain in the 401k account, there is no tax to be paid. However, once funds are withdrawn, they can be taxed. The tax is generally at your normal income tax rate.
Inheritors can implement a withdrawal strategy to help mitigate the taxes they may owe. There are several factors that impact the 401k inheritance, including:
- Your age.
- The account owner’s age at death.
- Your relationship with the account owner.
Some of the options for your 401k inheritance are:
- Rolling the money into your 401k or IRA if you are the account owner’s spouse. In this instance, it is as if the funds in the account belonged to the spouse all along.
- Withdrawing all the funds in a lump sum. This choice will result in maximum taxation and will require repayment in the same year.
- Withdraw all the funds within ten years of the account owner’s death. This choice provides the most flexibility.
- Spread your withdrawals out with annual RMD (required minimum distributions).
Inheriting an IRA
Estate taxes, if any, can also impact taxes. Finally, the age of the deceased can also impact the taxes you may be subject to. If you are the spouse of the deceased, you have the option to name yourself as the owner of a traditional IRA and even roll it into another IRA for yourself.
Other inheritors have a more comprehensive range of options, which should be discussed thoroughly with your IRA custodian.
Inheritance tax exists in only six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. It is a tax imposed on the inheritor or beneficiary from the estate of a deceased person.
The tax rate varies based on the state the deceased lived in, their relationship to the inheritor, and the value of the estate.
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