In short, yes, your inheritance is taxable. However, the full story is more complicated than a simple yes or no answer. Whether you’ll pay inheritance tax and how much you’ll pay depends on a variety of factors, including which state the deceased lived in and what your relationship to the deceased was. You could pay nothing — or you could pay as much as 18% of the value of the inheritance. Read on for a full primer on the taxes related to inheritance.
Is Your Inheritance Taxable?
The short answer: yes. Your inheritance can actually be taxed in two ways: inheritance tax and estate tax. However, you’re only responsible for paying inheritance tax. Estate tax comes directly out of an estate before it’s divided and distributed.
Whether you’ll actually have to pay an inheritance tax depends on which state the deceased lived in, as there is no federal inheritance tax. Only six states still impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. Even if you live in one of those six states but the deceased did not, you won’t have to pay inheritance tax. State laws are subject to change though, so always double check with your state tax agency.
A third way you end up paying for your inheritance is through state and federal income taxes. Inheritance isn’t typically considered income, but certain types of assets you inherit may have tax implications. You may have to pay taxes when you take the distributions from an inherited retirement account or when you sell inherited real estate or stocks.
What’s the Difference Between Inheritance Tax and Estate Tax?
You may hear the terms used interchangeably, but inheritance tax and estate tax are two distinct taxes. The most obvious difference between the two is who pays the tax. With estate tax, the tax is taken out of the deceased’s assets before they’re doled out to beneficiaries. With inheritance tax, the tax is levied after the inheritance is divvied up and distributed to beneficiaries.
Another key difference is that while inheritance tax is only levied by states, both the federal government and states may collect estate tax. However, the federal estate tax only applies to estates that are worth more than $11.4 million in 2019. Twelve states and the District of Columbia levy their own estate taxes, with the highest rate in Washington state, ranging from 10% to 20%.
Notably, the only state that currently collects both estate and inheritance taxes is Maryland. In Maryland, assets can be taxed both before and after distribution. In other states assets will only be taxed before or after distribution, or at neither time.
How Does Inheritance Tax Work?
Inheritance tax only applies if the deceased lived in one of the six states that levy inheritance tax. Even if you live in a state that has an inheritance tax, if the deceased lived in a state that did not have an inheritance tax you will not pay any inheritance tax.
You won’t have to pay inheritance tax until after the deceased’s estate has been divided and distributed to the beneficiaries. Unlike estate tax, which is collected from the deceased’s assets before they’re given to beneficiaries, inheritance tax is levied after distribution. The beneficiaries are responsible for paying inheritance tax.
Each beneficiary may owe a different amount. The amount that a beneficiary owes depends on how much he or she has received, what his or her relationship to the deceased is and in which state the deceased lived.
Inheritance Tax Exemptions
State inheritance tax rates are dependent on the beneficiary’s relationship to the deceased. In all six states, a surviving spouse is exempt from paying inheritance tax. New Jersey is the only state that has a complete exemption for domestic partners. Kids and grandkids are exempt from inheritance tax in each of the states except for Pennsylvania and Nebraska.
Exemption rates vary state by state for siblings, nieces and nephews, aunts and uncles and son- and daughter-in-laws. Generally, beneficiaries who don’t have a familial relation to the deceased will pay higher inheritance tax rates.
There are also monetary exemptions. For instance, Iowa does not tax inheritance if the net estate is valued at $25,000 or less. Maryland does not levy an inheritance tax if the total probate property value is less than $30,000.
How Much Is the Inheritance Tax?
Inheritance tax rates vary widely. As previously mentioned, the amount you owe depends on your relationship to the deceased. Inheritance tax rates range from 0% up to 18% of the value of the inheritance.
Here are the ranges for each of the six states that collect inheritance tax:
- Iowa: 5% to 15%
- Kentucky: 6% to 16%
- Maryland: 10%
- Nebraska: 1% to 18%
- New Jersey: 11% to 16%
- Pennsylvania: 4.5% to 15%
How Can I Protect My Inheritance From Taxes?
The most obvious – and perhaps the most logistically difficult – is to try to get your benefactor to move to a state that doesn’t have inheritance tax.
Moving aside, benefactors have the option of gifting his or her assets, or putting the assets into a trust. Instead of waiting until after they’ve died to dole out your inheritance, they could consider gifting a portion of it each year. Setting up a trust protects your inheritance from taxation.
The Bottom Line
Keep in mind that estate tax and inheritance tax are not one and the same. A benefactor pays inheritance tax after receiving his or her portion of the assets. Only six states – Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania – have an inheritance tax. Only Maryland levies both estate and inheritance tax. Inheritance tax rates vary depending on your relation to the deceased. As with anything tax-related, always be sure to double check state tax laws before doing anything, as these laws are subject to change.
Tips for Spending Your Inheritance Wisely
- Think before spending. As tempting as a shopping spree may be when you suddenly get a big chunk of change, think before spending. Consider putting your money into a savings account or a money market account while you decide how you want to use it.
- Assess your current situation before making any moves. Look for the area where you need the most help. Owe a lot of debt? Use your inheritance to pay that off. Behind on retirement savings? Add the funds to your retirement savings account.
- Don’t be afraid to ask for help. From finding out whether or not you owe inheritance taxes to deciding what to do with your inheritance, you have a lot to figure out. If you have any questions or uncertainties, consider working with a financial advisor. A matching tool like SmartAsset’s can help you find a financial advisor to work with who meets your needs. After you answer a series of questions about your situation and goals, the program will match you with up to three financial advisors in your area. You can then read the advisors’ profiles and interview them to choose who to work with in the future. This allows you to find a good fit while the program does much of the hard work for you.
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