Types of Taxes that Can Affect Your Inheritance
Receiving an inheritance? Here are 3 types of taxes that may affect your inheritance.
If you’re expecting to receive an inheritance any time soon, you might be wondering if you’re liable for any taxes. We have some good news and bad news for you. Bad news first: taxes on inheritance are a real thing. The good news: whether or not you’ll be held liable largely depends on the type of inheritance you received, and the state in which you live. More good news: this is your chance to educate yourself now so that you can plan ahead.
Before you begin spending any of your inheritance, it’s best to be informed on whether or not you’ll be liable for any of these taxes, and the estimated amount. Keep reading to find out what the different types of taxes on inheritance are, and when you might be subject to them.
Is Inheritance Taxable?
Yes, your inheritance may be taxable, but it depends on your unique circumstances. There are several factors involved, such as the type of inheritance received, its value, and where the decedent lived or owned property. (Decedent is the legal term describing the person who gave you the inheritance.)
“Do you pay tax on inherited money?” This question is asked all too often because there is no simple answer. To find out whether or not you’re liable for taxes on inheritance, it’s easiest to break it down into the three taxes that can impact an inheritance:
Inheritance Tax
Estate Tax
Capital Gains Tax
In most cases, you’ll only be responsible for paying inheritance tax, and even then, chances are small. Estate tax comes directly out of the estate before distribution, and capital gains tax is only assessed if you sell part of your inheritance. We’ll further explain each type of tax in the following sections.
1. Inheritance Tax
To get the full picture of your potential tax liability, you must look at both federal and state taxes. Luckily for you, the federal government doesn’t view inheritance as income. You only have to worry about inheritance tax at the state level, and even then, the chances you’ll owe taxes are pretty small.
That’s because there are only six states that collect an inheritance tax:
Iowa
Kentucky
Maryland
Nebraska
New Jersey
Pennsylvania
Note that each state has its own set of tax rules, but in general, the tax is only assessed based on where the decedent lived or owned property that they bequeathed to you. Even if they lived in one of these six states, you still might not get taxed, depending on your relationship to them. Learn more about each state’s inheritance tax rules here.
2. Estate Tax
You should also be aware of estate taxes that are due at the federal and state level. Luckily, the estate tax exemption at the federal level is currently set at just over $11.5 million. If your inheritance value is less than this amount, you won’t owe any taxes at the federal level.
State estate taxes tell an entirely different story. There are currently 12 states, plus the District of Columbia, that collect estate tax. The exemption for some of these states is as low as $1 million, so be sure to find out if your state assesses this tax, and what the exemption amount is.
Another important point to note is that estate taxes are paid by the estate. That means that when you receive your inheritance, any applicable estate taxes were already taken out. The amount received is the reduced amount, so you won’t have to pay taxes after the fact.
Because state tax rules vary, be sure to visit our guide, State-Level Estate Taxes and Inheritance Taxes that dives into an explanation on how these two types of taxes work at the state level.
3. Capital Gains Tax
Capital gains tax only comes into play if you decide to sell any part of your inheritance. Fortunately, capital gains tax isn’t as brutal as income tax, and is based on the asset’s current market value.
For example, let’s say grandma bequeathed you her house that she purchased for $200,000, but was worth $1 million at the time of her death. If you sell it, you’ll only be subject to capital gains tax based on the stepped up value of $1 million.
Other Common Questions About Taxes on Inheritance
Is Inheritance Considered Income?
Inheritance is not considered income at the federal level. However, any earnings you make from your inherited assets may be taxable.
Do You Have to Report Inheritance Money to IRS?
You do not have to report your inheritance money to the IRS if the estate value is under the exemption amount. Even if your inheritance was subject to the estate tax, the tax would have been collected before you received your inheritance. You will need to report any capital gains, which only applies if you decide to sell any assets that were included in your inheritance.
Do You Have to Pay Taxes on Money Received as a Beneficiary?
In general, you won’t have to pay any taxes on money or property you receive as a beneficiary. However, you might have to pay taxes on any income or capital gains you make off of an inherited asset. In addition, you would be subject to taxes if you withdraw money from any retirement or investment accounts you inherited.
In Conclusion - Do You Have to Pay Taxes on Inheritance?
In this guide, we explored three common taxes related to inheritance: inheritance tax, estate tax, and capital gains tax. The answer to the common question, “do you have to pay taxes on inheritance,” is “yes, maybe, but you may be exempt if you’re lucky.”
The answer largely depends on your unique circumstances. Some elements to consider include the types of assets you inherit, their value, and what you decide to do with them. It’s also important to keep in mind that federal and state taxes operate differently. The best thing to do is to stay informed on these tax categories at both the state and federal level, and whether you’ll be subject to any of them.
At Trust & Will, we’re here to help keep things simple. You can create a fully customizable, state-specific estate plan from the comfort of your own home in just 20 minutes. Take our free quiz to see where you should get started, or compare our different estate planning and settlement options today!
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