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 tax situation can dramatically change your tax bill.
What is inheritance tax?
Inheritance tax is a tax on the receipt of assets from someone who dies. For federal tax purposes, inheritance generally isn’t considered income, so you usually don’t need to report it. But at the state level, inheritances can be taxable. The person who receives the assets pays the tax.
Inheritance tax vs. estate tax
Inheritance tax and estate tax are two different things. Estate taxes are paid out of the deceased’s estate. 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 $11.4 million from the tax in 2019, so few people actually end up paying it. Plus, that exemption is per person, so a married couple could double it.
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. IRS Publication 559 has the details.
But that’s just at the federal level. Several states also collect estate tax (see the list of states here). Those states might have much lower exemption thresholds than the IRS. In Massachusetts, for example, estates worth $1 million or more could be taxable.
Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania tax people who receive inheritances, according to the American College of Trust and Estate Counsel. 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 inheritance tax.
But some people can get hit with a double whammy. Maryland has 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.
How to reduce inheritance tax
There are a few ways to minimize the tax bite on handed-down assets.
- One common element of estate planning is to give assets away before dying. Many states don’t tax gifts. (Learn how the gift tax works.)
- Gifts don’t have to be cash — stocks, bonds, cars or other assets count, too.
- Getting help from a qualified tax expert can be key.
Watch out for capital gains tax
- If assets appreciate after you inherit them, you might need to pay capital gains tax if you sell the assets.
- The capital gains tax rate 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.
- Certain types of inheritances might also create taxable income. For example, if you inherit an IRA or 401(k), the distributions you take might be taxable.
- States might have their own capital gains tax rules, so it’s a good idea to seek qualified advice.