Most of the time, only big estates feel the bite of taxes — odds are you won’t have to pay them. But there are exceptions, and the specifics of your inheritance situation can dramatically change your tax bill.
Estate taxes vs. inheritance taxes
Estate taxes and inheritance taxes are two different things. Estate taxes are paid out of the deceased’s estate, and inheritance taxes come out of the beneficiary’s pocket. One, both or neither could be a factor when someone dies.
An estate tax is a tax on the right to transfer property when you die. The IRS exempts estates of less than $5.49 million from the tax, so few people actually end up paying. Plus, that exemption is per person, so a married couple could double it, for an exemption of $10.98 million.
The IRS taxes estates above that threshold at rates of up to 40%. The IRS generally taxes the assets in an estate at their current fair market value, not based on the amount the owner paid for them.
Fourteen states and the District of Columbia collect estate taxes, too, according to the Tax Foundation, a Washington, D.C., think tank. And those states might have much lower exemption thresholds than the IRS. In Massachusetts, for example, estates worth $1 million or more could be taxable, says Chris Moss, a CPA and tax attorney with offices in Mount Pleasant, South Carolina, and Alexandria, Virginia.
“In Massachusetts, if you had a nice home and it was valued at more than $1 million, you would have to pay on that house in Massachusetts, but not to the IRS,” he says.
Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania tax people who receive inheritances, according to an analysis by the Tax Foundation. The rules regarding estate size and asset types can vary. Often, the deceased’s spouse and children are exempted, meaning money and items that go to them aren’t subject to tax.
But some people can get hit with a double whammy. Maryland and New Jersey have an estate tax and an inheritance tax, which means an estate might have to pay the IRS and the state, and then the beneficiaries might have to pay the state again out of what’s left.
Still, it’s an unlikely scenario for most.
“It’s mostly an East Coast thing,” Moss says. “States are slowly exempting children, husbands, wives, grandparents. Unless you give millions of dollars to, like, a friend down the block, you’re not going to get hit with an inheritance tax.”
What about income and capital gains taxes?
For federal tax purposes, inheritance generally isn’t considered income, so you usually don’t need to report it. But certain inheritances might create income, and that income could be taxable.
For example, if you inherit an IRA or 401(k), the distributions you take might be taxable. And if you inherit stocks, real estate or other items that appreciate, you might have to pay capital gains tax when you sell them.
The capital gains tax is based on, among other things, the profit you make. For example, if your father leaves you a stock portfolio worth $200,000 on the day he died, and you sell it all for $350,000 two years later, you might owe capital gains tax on the $150,000 gain.
States might have their own rules, so it’s a good idea to seek qualified advice.
Start giving it away
There are lots of ways to minimize the tax bite on handed-down assets. But estate taxes are complicated, so getting help from a qualified tax expert can be key.
One common element of estate tax planning, Moss says, is for owners to give away assets before death. The IRS allows taxpayers to give away $14,000 per year without incurring a gift tax. That $14,000 is per donee, which means a parent could give each of her kids $14,000 per year without incurring the tax, Moss explains. The gifts don’t have to be cash — stocks, bonds, cars or other assets count, too. Remember, though, that if those assets appreciate after you give them away, the beneficiaries could owe capital gains tax if they sell the assets.
“A lot of people kind of don’t see the value of it because they think, ‘Well, how much could you give away at $14,000 a year?’ Well, if you have four or five kids and a few grandchildren and some spouses, and you add all that up over 17, 18 years, that’s a lot of money,” he adds.
Tina Orem is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org.