Inheritance Tax: What You Need to Know

When a loved one passes, there’s usually a lot to process—from difficult emotions to estate management and more. While grieving, you may need to handle big financial questions and paperwork that arise from the estate. If a relative or friend has left you an inheritance, whether it's property or money, you may owe an inheritance tax.

Not everyone has to pay inheritance tax, though. Only six states require it, and some recipients are exempt based on their relationship to the deceased.

Knowing whether you owe inheritance tax is helpful for planning. And if you’re preparing your last will and testament, learn how to help your beneficiaries avoid taxes on your gift.

What is Inheritance Tax?

Inheritance tax is a state tax you pay on property or money you received after the death of a loved one. As the beneficiary, you’re responsible for covering this tax.

Inheritance taxes are calculated individually based on what you receive from the benefactor. Once the executor of the estate has divided and distributed the property, inheritance tax is assessed. Inheritance tax can be as low as 1 percent or as high as 18 percent depending on the state you’re in and what you inherited. For example, a state might charge 7 percent inheritance tax on bequests larger than $1 million. If your friend leaves you $3 million in her will, you’d pay 7 percent tax on $2 million, equaling $140,000. You would report this payment on an inheritance tax form.

It's important to note that an inheritance is not considered taxable income. For instance, if your uncle leaves you $20,000, you don’t need to claim that as income on your state and federal tax returns.

Inheritance Tax vs Estate Tax

It’s easy to confuse inheritance tax with estate tax. They both involve paying taxes on property or money you received from a deceased loved one but how they're calculated and who pays each of them differs.

An estate tax is a federal tax, so all estates are eligible, but the tax is only levied on large estates. Each year, the IRS establishes the amount that’s excluded from the tax. In 2019, estate tax is only imposed if the value of the estate is over $11,400,000. Only the amount beyond that limit will be taxed. In other words, estate tax impacts only the wealthiest heirs in the United States. Only 2-3 percent of taxpayers ever encounter estate tax. Some states also impose an additional estate tax on top of the federal one.

The other distinction between the two taxes is who is responsible for paying. Estate tax is imposed on the entire estate of the deceased person before it’s distributed and the tax is then paid by the estate. For example, if Jamal passes away, an estate tax would be levied on the total value of his estate and paid with the estate’s funds. The remainder of the estate would then be divided and distributed. This is different than with inheritance tax, which is paid by each individual after they've received their amount from the estate.

Who Has to Pay Inheritance Tax?

Depending on where you live and how much you inherit dictates if you need to pay inheritance tax. The federal government doesn’t impose an inheritance tax, only certain states do. If you live in Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania, you may have to pay inheritance tax.

Other exemptions depend on your relationship with your loved one. In all states, spouses are exempt from paying tax on what they inherit from their deceased husband or wife. In many states, children and dependents also receive exemptions, but sometimes on only part of the inheritance.

In general, higher tax rates are imposed when you inherit money or property from someone who you don’t have a familial relationship with. For instance, if a friend leaves you money, you may be taxed at a higher rate than if you received something from your sister.

State laws are subject to change, so be sure to check with your state’s tax agency before completing an inheritance tax form.

What About Federal Inheritance Tax?

A federal inheritance tax doesn't exist. Inheritance tax is imposed in only six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If you live in the other 44 states, you won’t have to worry about paying it. The federal estate tax is different, though, and may apply to the estate of your loved one—no matter the state.

Remember that an inheritance isn’t considered taxable income. If a neighbor leaves you $10,000, you won’t need to claim it as income on your taxes.

How to Plan for Inheritance Tax

Aside from inheritance tax, subsequent earnings and income from the inheritance is taxable at the state and federal levels. For instance, if you invested the $20,000 that your aunt left you, and it receives a 4 percent return for the year, you'd owe taxes on the earnings.

If you sell a property you inherited, like a house or plot of land, the profit is taxed as a capital gain. For instance, if a property is worth $200,000 when you receive it, and you sell it for $225,000, you'd pay capital gains tax on the $25,000 profit. The amount you pay in either short-term or long-term capital gains depends on your tax bracket and how long you’ve had the investment. On the other hand, if you sell the property for less than what it was worth when you received it, it’s considered a capital loss and no tax is due.

In most cases, since you may not be expecting it, it’s difficult to plan for an inheritance. Should you invest it, keep it, or sell it? These are decisions to make on an individual basis. Talk with an attorney or financial planner to determine what's best for your situation.

If you're creating a will or estate plan, consider the state you live in and which taxes your beneficiaries might be subject to. If you live in a state with inheritance tax, you might wish to give your property away as a gift before your passing, rather than as an inheritance. Gifts are not taxed and could save your loved one money.

Summing Up

When someone you love passes, there can be a lot of details to take care of. In most cases, beneficiaries are exempt from inheritance tax based on where they live and their relationship with the deceased. If you do pay inheritance tax, remember that it is a one-time tax. Other taxes owed on earnings from the inheritance, such as capital gains, will be requested on annual tax filings.

Knowing how to invest your inheritance can help you continue your loved one’s legacy for many years to come.