If you’ve recently inherited assets or anticipate doing so, you may have mixed feelings, compounded by questions about inheritance tax. It can indeed be intimidating but affects only a select group since few states impose it. If you’re in one of these states, the particulars of your inheritance can greatly affect your tax responsibilities. This article aims to demystify what inheritance tax is, how it functions, and strategies to possibly lessen its impact on your inheritance.
Read: Tax 101: Basics You Need to Understand
The Reality of Inheritance Taxes
Inheritance taxes concern only a small percentage of heirs, as few states impose them. This greatly reduces the chance that most people will need to pay it. However, if you live in a state that does tax inheritances, factors like the asset value and your relationship to the deceased can affect your tax bill. Thus, while it might seem daunting, it impacts only a small group of beneficiaries.
What is Inheritance Tax?
An inheritance tax applies to money or property received from someone who has passed away. It’s the recipient who owes the tax, and the amount varies depending on the inheritance size and the relationship to the deceased. Typically, the tax must be settled within months of the person’s death.
State-Level Taxability of Inheritances
The obligation to pay inheritance tax depends on state laws, the specifics of your inheritance, and your personal tax situation. States may tax inheritances from non-immediate family members more heavily, while direct relatives like spouses and children often receive exemptions.
States with Estate and Inheritance Taxes
Below is a table that categorizes states in the United States based on their implementation of estate taxes, inheritance taxes, or both. This table helps identify which states impose each type of tax, providing a clear overview for estate planning or understanding potential tax liabilities on inheritances.
| States with Only Estate Taxes | States with Only Inheritance Taxes | States with Both Taxes |
|---|---|---|
| Connecticut | Iowa (phasing out by 2025) | Maryland |
| Hawaii | Kentucky | |
| Illinois | Nebraska | |
| Maine | New Jersey | |
| Massachusetts | Pennsylvania | |
| Minnesota | ||
| New York | ||
| Oregon | ||
| Rhode Island | ||
| Vermont | ||
| Washington | ||
| District of Columbia |
Federal Inheritance Taxes: A Non-Issue
Unlike some misconceptions, there is no federal inheritance tax. As abovementioned, only six states—Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania—currently tax inherited assets. Notably, Iowa is phasing out its inheritance tax, set to be completely abolished by 2025.
Distinguishing Between Inheritance and Estate Taxes
It’s important to understand the difference between inheritance and estate taxes. Inheritance taxes are paid by the recipient of the assets, whereas estate taxes are deducted from the estate of the deceased based on its total value. While there is no federal inheritance tax, the U.S. does impose a federal estate tax on estates valued over $13.61 million as of 2024, with rates ranging from 18% to 40%.
In states such as Maryland, where both estate and inheritance taxes are levied, beneficiaries might encounter the issue of double taxation. This occurs when the estate is taxed on its overall value before assets are distributed, and then beneficiaries are also taxed on what they inherit. Although this scenario is daunting, it is relatively rare, with most states choosing to implement only one form of tax.
Capital Gains Taxes on Inherited Assets
Capital gains taxes are another potential financial burden for beneficiaries. This tax applies if inherited assets like stocks or real estate appreciate by the time they are sold. For example, if you inherit stocks worth $200,000 and sell them for $350,000, you owe capital gains taxes on the $150,000 profit. Beneficiaries must know the original value (or basis) of these assets at the time of inheritance to accurately assess capital gains tax liabilities.
Strategies to Minimize Inheritance Taxes
Living in a state that imposes inheritance taxes requires thoughtful planning to minimize tax liabilities. Here are some effective strategies to consider:
- Consult Tax Experts: Inheritance taxes can be intricate and vary significantly from one state to another. Engaging with tax professionals who understand these nuances can provide guidance tailored to your specific situation. They can help devise strategies that comply with local tax laws while minimizing your tax burden.
- Strategic Gifting: One common approach to reduce these taxes is through strategic gifting. By transferring assets during your lifetime, you can significantly decrease the taxable value of your estate. Many states offer exemptions for gifts. Which means that these transfers may not incur the same taxes as those levied on inheritances. This can include cash, stocks, real estate, or other valuable assets.
- Utilize Trusts for Asset Protection: Trusts are effective for estate planning and can protect your assets from excessive taxes. Placing assets in living trusts, irrevocable trusts, or grantor retained annuity trusts helps manage your estate as you wish. This arrangement can lessen the inheritance tax burden on your beneficiaries. Trusts can be tailored to maximize tax savings and ensure private, efficient asset transfer.