Understanding Inheritance Taxes: What You Need to Know

Inheritance taxes often loom large in the minds of potential heirs, creating anxiety about potential financial burdens. However, the reality of inheritance taxes is far less daunting: only a few states impose such taxes, meaning the majority of Americans won’t have to worry about them. If you do reside in a state with inheritance taxes, understanding the specifics of those taxes can help you navigate the complexities of your inheritance and potentially minimize your tax liabilities.

What is Inheritance Tax?

An inheritance tax is a tax that applies to the assets inheritance, such as money or property, received from a deceased person. Unlike estate tax—which is levied on the deceased person’s estate before distribution—inheritance tax is the responsibility of the heir who receives the assets. The rates can differ based on the size of the inheritance and the relationship between the deceased and the inheritor. Typically, inheritance tax returns and payment deadlines fall within a few months following the death of the loved one.

When is an Inheritance Taxable?

Inheritance taxes generally come into play when assets transition to individuals who are not considered immediate family members, such as friends or distant relatives. In most cases, there are exemptions in place for spouses, and sometimes for children of the deceased, meaning they may not owe any inheritance tax at all.

Each state sets its own specific exemptions; for example, if your state has a threshold of $10,000, and you inherit an item valued at $15,000, you may only owe taxes on the $5,000 that exceeds the threshold. Understanding the rules in your state is crucial to determining your tax obligation.

Is There a Federal Inheritance Tax?

Good news: there is no federal inheritance tax. As of 2024, only six states – Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania – impose taxes on inherited assets. Notably, Iowa is set to phase out its state inheritance tax entirely for deceased individuals passing away on or after January 1, 2025, lowering the pressure for individuals in that state.

How Much is Inheritance Tax?

Because inheritance taxes are determined by state law, the amount you might owe depends on various factors, including your state’s tax policies, the size of your inheritance, and your relationship to the deceased.

Inheritance Tax Rates by State

Here’s a brief overview of what you may expect for inheritance tax rates per state that imposes such taxes:

• Maryland: Rates vary from 0.8% to 16%, depending on the value of the inheritance. Immediate family members typically have a more favorable treatment.

• New Jersey: The state employs a tiered rate ranging from 11% to 16%, with close relatives facing lower rates and a higher exemption threshold.

• Pennsylvania: This state generally assesses a flat rate of 4.5% to 15% based on the relationship to the deceased, with spouses typically exempt from taxation.

• Kentucky: Ranges from 4% to 16% based on the inheritance amount and the heir’s relationship.

• Nebraska: Taxes can range from 1% to 18% depending on the inheritance value and relationship.

• Iowa: Similar to Kentucky and Nebraska, with rates from 0% to 15%, depending on the total value of inherited assets.

It’s vital to fact-check with your state’s tax department, as rules can change frequently.

Inheritance Taxes vs. Estate Taxes

It can be easy to confuse inheritance and estate taxes, but they are fundamentally different. Inheritance tax is levied on the beneficiary, while estate tax is taken out of the deceased’s estate before assets are distributed. Additionally, while there is no federal inheritance tax, there is a federal estate tax. As of 2024, this applies to estates valued over $13.61 million, with rates ranging from 18% to 40%.

Some states can compound the confusion; Maryland, for instance, has both an estate tax and an inheritance tax, potentially leading to double taxation for the beneficiaries.

Do You Pay Capital Gains on Inheritances?

If you choose to sell inherited assets, you could incur capital gains taxes on any appreciation beyond the value at the time of inheritance. For example, if you inherit stock worth $200,000 on the date of passing and sell it two years later for $350,000, you would owe capital gains taxes on the $150,000 gain. Inherited assets typically receive a "step-up" in basis, which means they are valued at the current market rate at the time of inheritance, potentially reducing capital gains liabilities.

However, taxable income can arise from certain inherited accounts like IRAs or 401(k)s, further complicating your tax situation.

How to Avoid Inheritance Tax

If you’re concerned about potential inheritance taxes, several strategies can help you minimize your tax bill:

1. Gifting: Many states exempt gifts from taxation, so gifting assets before passing away can limit the taxable inheritance amount.

2. Establish Living Trusts: Trusts can provide various benefits, including potentially bypassing frequent inheritance taxes.

3. Consider Other Estate-Planning Techniques: Irrevocable trusts and grantor retained annuity trusts (GRATs) can help secure valuable assets for your heirs while managing tax obligations efficiently.

Conclusion

While inheritance taxes are a reality in certain states, understanding the tax laws that apply to your specific circumstance can significantly ease the burden. Knowledge about exemptions, potential rates, and planning strategies can help you make informed decisions and provide clarity during a challenging time. Always consult a qualified tax professional or estate planner to help navigate the complexities of inheritance and potential tax implications, ensuring a smoother financial transition for you and your beneficiaries.