Imagine getting great news that you just received a large inheritance from a long lost relative. Now imagine getting the bad news that you might owe a large inheritance tax on that money or property you just received. Depending on where the deceased person lived, you might have to pay taxes on inheritance that you receive. The tax rate and total amount you owe depends on a few factors. In this article, we will discuss everything you need to know about the inheritance tax in 2021. If you are named in someone’s will, you will fully understand the tax implications of the inheritance and be prepared to handle it appropriately.
What Is An Inheritance Tax?
An inheritance tax is a tax on any assets that you receive as an inheritance from a decedent’s estate. You might also hear this referred to as the death tax. You might receive the inheritance in a couple of different ways. Perhaps the decedent specifically listed you in the will as an heir and maybe even described the specific property or assets you were to receive. Alternatively, the deceased person may not have had a will at all. The intestate succession laws of the state where the deceased lived might say that you are to receive an inheritance based on your relationship to the deceased. Either way, the inheritance you receive might be taxable.
Inheritance taxes are paid at the state level. There is no federal inheritance tax. There are federal estate taxes, but those will be discussed in the next section of this article. Some states require the payment of inheritance taxes while others do not. So, you might get lucky and inherit assets from a state that has no inheritance tax. This means that you will receive that inheritance tax-free, regardless of how large the inheritance might be! If the deceased lived in a state that does require the payment of inheritance taxes, then you must claim your inheritance on your state tax return. When it comes time to pay your income taxes for the year, you will also be required to pay up for any taxes due on the inheritance you received.
Difference Between Inheritance Tax And Estate Tax
When it comes to estate planning, one of the main goals is to reduce the amount of taxes that will be due as much as possible. So, what is the difference between an estate tax and an inheritance tax? These two things sound very similar, but they are completely separate and different. Here are the basics.
First, estate tax liability starts at the federal level. The IRS is responsible for calculating and collecting estate tax while Congress sets the estate tax rates. Inheritance tax, on the other hand, is a state-level tax. The individual state in which the deceased lived will calculate and collect the tax on your inheritance. Unfortunately, there are some states that have both inheritance taxes and state estate taxes. There are also differences in reporting of the tax. With estate taxes, the estate of the deceased is treated as its own legal entity. The estate must obtain a Federal tax identification number, and the estate is required to file tax returns. With an inheritance tax, the inheritance must be claimed by each individual beneficiary. For example, if you and your brother each receive a $10,000 inheritance from a grandparent, then you would each claim that $10,000 on your individual income tax returns with your state while there would be no need to include it on your federal income tax return. The reporting on your tax forms needs to take place in the tax year in which you received the inheritance.
Lastly, calculation of the tax due varies between the two. Estate taxes are calculated at the estate level. All the assets of the estate are added together to obtain the total value of the estate. Once the estate tax exemption has been subtracted, then taxes are due on the remainder of the taxable estate. However, with an inheritance tax, the tax is calculated on an individual beneficiary basis. Regardless of the size of the overall estate, you are only responsible for paying taxes on the amount of the inheritance that you received.
Another important factor to remember is that the inheritance tax due is calculated on the market value of the assets when they are distributed to the beneficiary (not at the date of death). If the value of those assets fluctuates, especially if it increases, then you might be responsible for additional taxes later. This could include capital gains taxes which are collected at a very high rate. For instance, suppose your mother died and left you mutual funds valued at $50,000. You decide to sell the funds a year later, and they are then valued at $75,000. You will likely be responsible for paying capital gains taxes on the $25,000 of appreciation that you gained from the portfolio.
2021 Inheritance Tax Rates & Exemptions
As previously mentioned, not all states require the payment of inheritance taxes. Only six states levy this tax in 2021. These are Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania, and Iowa. Even in the states that do enforce these taxes, most of those states allow an exemption of part of the inheritance. This means that no taxes would be due on the inheritance unless the value exceeds the exemption amount. Once the exemption amount has been exceeded, the tax rates typically follow a sliding scale. This is similar to the way that income taxes work. The larger the inheritance, the higher the tax rate will be.
In addition to the value exemptions mentioned above, some states also take the overall size of the estate into consideration. In Maryland, for example, any inheritance from an estate valued below $50,000 is exempt from an inheritance tax. Finally, many states will take into consideration the relationship to the deceased. Immediate family such as a surviving spouse, child, or parent is often exempt from paying taxes on an inheritance received from the deceased.
| 2021 Estate Tax Guide | ||
| Exemption Rules | Tax Rates | |
| Iowa | Immediate family (spouse, parent, child) exempt | 0% – 15% |
| Kentucky | Immediate family (spouse, parent, child, sibling) exempt | 0% – 16% |
| Maryland | Immediate family (spouse, parent, grandparent, child, grandchild, sibling) and charities exempt | 0% – 10% |
| Nebraska | Spouse or charity exempt | 1% – 18% |
| New Jersey | Immediate family (spouse, child, parent, grandparent, grandchild) and charities exempt | 0% – 16% |
| Pennsylvania | Spouse and minor children exempt | 0% – 15% |
Ways To Reduce Your Inheritance Taxes
People should always be looking for ways to reduce their inheritance and estate taxes, and there are multiple ways that you can do this. One of the most common ways to reduce these taxes is by establishing an irrevocable trust. When the trust is funded, you transfer ownership of property and assets to the trust. This effectively removes those assets from your estate. That means that the assets are not included in the valuation of your estate for tax purposes. An estate with a lower value will owe fewer taxes, if any, than an estate with a larger value. While some gift tax may be due at the time of the transfer, it will likely still be much less than the estate tax liability would have been.
Similarly, by removing these assets from your estate, they will no longer be subject to inheritance tax. Assets may be transferred and distributed from a trust to the beneficiaries without payment of taxes. Since these assets are not included in your estate, they are no longer considered an inheritance when passed to the beneficiaries.
Another way to reduce that inheritance tax bill is by purchasing life insurance policies that are payable to your beneficiaries. Life insurance proceeds are generally not taxable, and you can specify the amount that you would like each beneficiary to receive simply by purchasing a policy for that amount. Generally, life insurance policies are not considered part of your estate as long as you have a named beneficiary, so this method can lower both your estate taxes and inheritance taxes. In some cases, people choose to establish a life insurance trust to receive the proceeds from the policy. This is common when someone has minor children or other loved ones that might need a trustee to manage the funds from the policy.
The Bottom Line
Payment of taxes on an inheritance might not seem fair, but it is a reality in several states today. The taxes are based on the value of the individual inheritance that you receive from the deceased, and you must claim this amount on your state income tax return. Failure to do so could result in large penalties and fines from the Department of Revenue in your state. Since the Federal government does not tax inheritances, you do not have to worry about claiming it on your return to the IRS. If you have received an inheritance or anticipate one in your future, then make sure that you are familiar with the tax laws in your state. If you have any questions or doubts, you should always consult a tax professional to make sure that you are properly claiming any inheritance that you receive.
Frequently Asked Questions
Do beneficiaries have to pay taxes on inheritance?
It depends on the state in which the deceased lived. There is no federal taxation on inheritance. However, some states do assess an inheritance tax. In the states that levy taxes on inheritance, the tax rates typically average around 10% and are adjusted on a sliding scale. While you might be able to receive a small inheritance tax-free because of the exemption amount, you will pay higher taxes on larger amounts. The higher the value of the inheritance you receive, the higher the tax rate you usually are required to pay. Even if you live in a state that levies this tax, if the deceased person lived in a state that did not require the tax, then you will likely not be subject to paying a tax on the inheritance.
How much can you inherit from your parents without paying taxes?
Many people wonder, “Is inheritance taxable even if it comes from your parents?” Again, the answer to this question depends on the state in which the deceased lived. Several of the states that do levy an inheritance tax allow exemptions for immediate family like spouses, parents, children, and siblings. Some states limit the exemptions to spouses. For instance, Nebraska only allows a full exemption for spouses and charities. Children are only exempt up to $40,000. In Pennsylvania, adult children are only allowed an exemption up to $3,500. In Kentucky, Maryland, Iowa, and New Jersey, children are completely exempt. If you live in one of the following states, then you might be faced with both inheritance and estate taxes: Connecticut, District of Columbia, Hawaii, Illinois, Maine, Massachusetts, Maryland, New York, Oregon, Minnesota, Rhode Island, Vermont, and Washington. These states levy estate taxes as well in addition to the federal estate taxes that will be due.
Do you have to report inheritance money to the IRS?
If you inherit assets like cash, real estate, or even an IRA, do you have to report that inheritance to the IRS? In most cases, no, you are not required to report this on your federal tax return. In fact, there is no federal inheritance tax. This tax is only collected at the state level. If you live in a state that collects this tax, then you will be required to report the money or the value of the assets you received on your state tax return. Depending on the value of the assets and your relationship to the deceased, you might be able to exempt a portion or even all of the value of the assets. Close family members like parents, children, and even siblings in some cases are allowed certain exemptions on inheritance that prevents them from being required to pay taxes on a portion of the inheritance.
Do you have to pay inheritance taxes if you are the beneficiary’s spouse?
The beneficiary is responsible for paying the taxes on the inheritance. First, you need to determine whether any inheritance tax is even due. Perhaps you live in a state that does not levy an inheritance tax, or maybe you are allowed an exemption so that you do not have to pay taxes on the inheritance. If you have determined that there is an inheritance tax due, then the beneficiary is responsible for claiming and paying the tax. If you file separate tax returns, then you will not be required to report the inheritance on your return. However, if you file a joint return like most married couples, then the inheritance will need to be claimed on the return and paid by either you or your spouse.
How is inheritance tax calculated?
The amount of tax due on an inheritance is calculated based on the market value of the inheritance at the time of the distribution to the beneficiary. The tax is calculated for each individual beneficiary. Here is how the tax would be calculated. First, determine the value of the assets that are being inherited. For cash, this is very straightforward as it is simply the amount of cash inherited. For other assets like real estate, determining the value can be slightly trickier.
Once the value has been assessed, you should determine whether you qualify for any exemptions based on the value of the assets or your relationship to the deceased. If you do, then subtract that amount from the total value of the inherited assets. This will give you the amount of the taxable inheritance. From there, you should determine the tax rate at which the inheritance will be taxed by using your state’s specific tax rates. Simply multiply the taxable amount of the inheritance by the tax rate. We will walk through a simple example below.
Let’s assume that you inherit $50,000 from your brother. The state in which your brother lived allows a $10,000 exemption for siblings. So, the taxable income amount of the inheritance would be $40,000. If the tax rate for a $40,000 inheritance is 10%, then you as the taxpayer would owe $4,000 in taxes on that inheritance.