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Taxes

8 Minute Read

How Does Inheritance Tax Work?

8 Minute Read

Someone's Will with the words

Even though receiving an inheritance can be a big blessing, it may mean you’re dealing with a painful loss. On top of that you may be thinking about what to do with your new inheritance and how an inheritance tax might apply. Before you know it, things can start to feel overwhelming pretty quickly.    

Whether this is you or you’re considering leaving an inheritance and wondering how taxes could affect it, we’ll walk you through how it works.           

Let’s start with the basics.

What is the Inheritance Tax?

An inheritance tax is a state tax that you would pay on an asset (like property or money) you receive from someone who has passed away.

An inheritance tax is a state tax that you would pay on an asset (like property or money) you receive from someone who has passed away.

Once upon a time, all 50 states had the inheritance tax, but over the years more states have done away with it. (Can we get an amen?) These days, only a handful of states still have the tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Don’t let taxes stress you out. A tax pro is the way to go!

When thinking about the inheritance tax, there’s three big considerations. Who is the inheritance coming from (parent, cousin, uncle, etc.)? What is the amount? And what state do you and/or the inheritance reside in?

When thinking about the inheritance tax, there’s three big considerations. Who is the inheritance coming from (parent, cousin, uncle, etc.)? What is the amount? And what state do you and/or the inheritance reside in?

Who Pays the Inheritance Tax?

Let’s just get the not-so-good news out of the way. If your loved one lived in one of the six states, your inheritance might be on the hook for the tax. We say might because many beneficiaries—such as spouses, children and grandchildren—are actually exempt from paying any inheritance taxes. But that’s not necessarily the case for cousins, in-laws or more distantly related family members. Again, each state is different.

On the other hand, if your loved one lived in any of the other 44 states where the asset or property you’re inheriting is located, you can, in most cases, collect your inheritance tax-free—even if you live in one of the six states with the tax. (This should be music to your ears!)    

How Do Inheritance Taxes Work?

Now for some good news. Uncle Sam doesn’t have an inheritance tax and inheritances are not considered taxable income in most cases—so you won't have to report your inheritance on your state or federal income tax return.

For example, if your father-in-law from a no-inheritance-tax state leaves you $25,000, and you live in, say, New Jersey - a state with an inheritance tax exemption threshold of $25,000 for siblings and children-in-law - that wouldn’t be considered income and you would be free to enjoy the inheritance without worrying about taxes.

On the other hand, let’s say you your father-in-law lived in New Jersey, and he left you $50,000. You would pay an inheritance tax of 11% on the remaining $25,000 ($50,000 - $25,000) when it passes to you.

Each state is different and taxes can change at the drop of a hat, so it’s a good idea to check your states tax laws, or better yet, talk to a tax pro!    

Inheritance Tax by State

Tax rates and laws vary depending on the state and rates are generally based on how closely related the person inheriting the assets is to the deceased. The more distantly related you are and the higher the amount, the higher the tax rate goes.

Kentucky’s rates, for example, can be as low as 0% and as high as 16%, while the rate in New Jersey can be anywhere from 11% all the way up to 16%.

There isn’t a one-tax-rate-fits-all approach within the six states. Most of them use a progressive scale which basically means that there are tiered tax brackets depending on how much the inheritance is.

The exact tax rate you might owe on an inheritance depends on how closely related you are to the deceased and the tax exemption threshold for your state.

The exact tax rate you might owe on an inheritance depends on how closely related you are to the deceased and the tax exemption threshold for your state.

To stick with New Jersey as an example, remember that the tax exemption amount for siblings and children-in-law is $25,000. So anything under that you wouldn’t pay an inheritance tax. But, anything over that amount up to $1,075,000 will get hit with an 11% tax.

Keep in mind that tax rates can, and do, fluctuate depending on the state. We recommend you connect with a tax Endorsed Local Provider (ELP) to help you cover all your bases. When in doubt, reach out!

What about retirement accounts and real estate?

One important note: Some types of inheritances - like a 401(k) or a traditional IRA - are subject to other pesky taxes, like income taxes . Retirement accounts like these can get sticky and distributions (the amount of money you take out of a retirement account) are typically taxable. We know, it’s a lot, but hang in there.      

Similarly, if you inherit a piece of property and sell it, you may have to pay a capital gains tax. That just means you’re taxed on any profit you make above the value of the property at the time of your loved one’s death and when you inherited it.

Both of these situations can get real confusing real fast, so you should get with a tax pro to make sure you’re covering all your bases.

What’s the Difference Between Inheritance Tax and Estate Tax?

 It’s easy to get the  inheritance tax and estate tax mixed up since those terms are often used interchangeably. But they are, in fact, two different types of taxes. The best way to differentiate between them is to remember who is responsible for footing the bill.

It’s pretty simple: The estate is responsible for paying the estate tax while the lucky person inheriting is responsible for paying the inheritance tax.      

The estate tax is a federal tax on the transfer of the estate before any of the assets are given out. The federal estate tax is only assessed on estates worth more than $11.58 million for 2020. The inheritance tax is imposed on an asset that you inherit.

Anything that the estate owes will be taken care of by the estate before any inherited assets are handed out. Since estate taxes are collected before the inheritance is passed down, you won’t have to worry about it. Cue the sigh of relief!

The inheritance tax, on the other hand, is based on the value of the assets you inherit from someone’s estate. This means that you—the person inheriting—would be responsible for paying up, if it applied.

That said, the inherited assets have to be worth more than a certain amount before taxes are due. For the 2020 tax season, those thresholds sit at about $1 million. So only about 2% of taxpayers will even run into this tax.

Inheritance Tax Exemptions

Let's talk exemptions—a.k.a. how you might be able to avoid having to pay the inheritance tax.

If  one spouse dies, the surviving spousedoesn’t have to pay the inheritance tax in any of the states that collect it. And only Nebraska and Pennsylvania currently impose the tax for kids and grandkids.           

The inheritance tax also doesn’t apply if you are gifted an amount before your loved one passes away. Receiving a gift not only benefits you, but also reduces the value of your loved one’s estate (remember, the estate tax is collected based on the value of the estate). Most states don’t tax gifts under a certain amount—typically $15,000 per person per year. So, if it’s under that threshold, your gift is tax-free. (What a wonderful phrase!)

Find a Tax Pro  Near You

Just as you wouldn’t go through the grieving process alone, you don’t need to figure out this whole inheritance thing alone, either—especially if you’re considering investing it (which is a great idea, if you’ve already paid all your debt!) or you just feel lost about how taxes come into play.

When you’re ready, we’ll connect you with a  trusted tax  professional  who can walk you through your options and help make investing feel like a walk in the park. (Your future self will thank you.)

Find your Tax Pro today!                                     

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How to Claim Dependents on Your Taxes

If you’re like many people, anything related to taxes such as how to claim dependents can be enough to give you a never-ending headache during tax season. Read on below to check out how simple it really is.

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Tax Pro or File Your Own?

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Use this free quiz to help you decide which tax filing method is right for you.
 
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