The process of planning an inheritance can be an emotional one. You’re likely looking back and seeing how far you’ve come by reflecting on the legacy that you’ve built. Naturally, you’ll want to figure out the best possible way to pass on your inheritance to loved ones. This is cause for proper estate planning, which includes understanding the different tax implications.
In this guide, we’ll explain the different types that could potentially affect your inheritance, as well as strategies to avoid them.
- What is Inheritance Tax?
- The 3 main types of Inheritance Taxes
- 4 ways to protect your inheritance from taxes
What is inheritance tax?
Inheritance tax is a type of tax that is levied by select state governments. The Internal Revenue Service (IRS) doesn’t impose an inheritance tax, so you don’t have to worry about it on the federal level.
Inheritance tax comes into play when an individual inherits an estate from a deceased person. Is inheritance taxable? Whether or not they are subject to the inheritance tax depends on the state the person lives in, their relationship with the deceased, and the value of the inheritance.
To clarify, inheritance tax isn’t the only type of tax that can affect your inheritance. There are other types of taxes that can be levied, at both the federal and state levels. In the next section, we’ll go over the three types of taxes you need to look out for, and how each of them works.
The 3 main types of inheritance taxes
When someone talks about inheritance taxes (with the infamous nickname “death taxes”), what they’re really referring to is the grouping of different taxes that can affect an inheritance. There is an inheritance tax specifically, but it’s just one of the different taxes that are assessed by the IRS and state governments.
What’s even more confusing is that some taxes are imposed at the federal level, while others are not. To add to the confusion, only a few state governments levy these taxes.
Clear as mud? We thought so. Don’t worry because we’re here to break down the 3 main types of inheritance taxes so that you can walk away feeling confident:
- Inheritance Tax
- Capital Gains Tax
- Estate Tax
1. Inheritance Tax
Explained earlier, the inheritance tax is levied when an individual receives an inheritance. We can think of this one as the literal inheritance tax. There is no federal inheritance tax, and is only assessed by the following six states only:
- New Jersey
Inheritance taxes are only imposed on any amount exceeding the threshold defined by each state. This means that even if you live in one of the above states, you still might not be subject to the tax if you’re under the threshold. You might also be exempt based on your relationship with the deceased; immediate family members are often spared.
We recommend visiting your state’s tax board website to research the tax exemption amount, exempt persons, and the tax rate. Note that the tax rate is often a sliding scale, roughly between 5% and 15%, based on how much the inheritance exceeds the exemption amount.
2. Capital Gains Tax
Capital gains tax is levied by the federal government and state governments. These taxes are assessed when you sell an inherited asset.
Luckily, capital gains taxes are more forgiving than income taxes. This is in part because they’re only assessed on the profit you made off the “stepped-up in basis” value.
We’ll use an example to help explain.
Let’s say that you inherited a house from your grandmother. She originally purchased it for $50,000, but it was worth $100,000 at the time of her death. $100,000 is the stepped-up in basis value. A few years later, you sell the house for $125,000. Luckily, you’re only subject to capital gains tax on the $25,000 you made off the stepped-up in basis amount, instead of the original purchase price of the home.
The average state-level capital gains tax rate is around 29% unless you’re one of the lucky few who live in a state with no income taxes. The federal capital gains tax is on a sliding scale based on your income bracket. The Tax Foundation offers a graphic showing the combined federal and state capital gains tax rate for each state.
3. Estate Tax
Whether or not any estate taxes are due depends on the size of the estate.
According to the IRS, the federal estate tax threshold for 2023 is $12,920,000.1 An estate only owes taxes if its fair market value exceeds this threshold.
Fortunately, this high number means that most estates won’t owe any estate taxes at the federal level. However, if you do exceed this threshold, then you’ll be facing a tax rate of 40%.
Note here that we’ve carefully used wording implying that it’s the estate that owes the tax, and not the individual who inherits the estate. That’s because estate taxes are levied upon the decedent’s passing and are to be paid before any distributions are made. The appointed trustee of the estate is responsible for paying taxes out of the estate.
You may be facing a double whammy if you live in one of the following states that also impose an estate tax:
- New York
- Rhode Island
- Washington DC
The threshold for these states ranges anywhere between $1 million and $7.1 million, so be sure to check your local threshold and rate.
5. Common inherited assets
It’s also helpful to understand what types of assets are commonly included in an inheritance, and what kind of tax they might be subject to.
In general, inherited assets belong to the following categories:
- Stocks and Cash
- Retirement Accounts
- Real Estate
- Art and other Collectibles
- Life Insurance Policies
Although you generally won’t owe any income tax when you inherit cash, you may be liable if you receive cash payments that would have been taxable for the decedent. Examples include salary payments, bonuses, or IOU payments that are made after their death. In addition, you’ll be liable for any capital gains tax from income made off of stocks and securities.
IRAs and 401ks are just two examples of retirement accounts, which tend to be income tax sensitive. Any distributions from retirement accounts will be taxable as income. We explain how to help minimize distributions a bit later.
Real estate can be subject to both capital gains tax and income tax, but only in certain circumstances. If you decide to sell an inherited property, then you’ll be subject to capital gains tax.
Explained earlier on, you’ll only be taxed on any profit made using the stepped-up in basis value of the property. Arts and collectibles work very much in the same manner. You would only be liable to income tax if you decide to rent out inherited property, although you can write off your taxes as a business expense.
Life insurance policies are well-loved from a tax perspective. That’s because proceeds from a life insurance policy are not taxable. That means that the beneficiary doesn’t have to pay any income tax on them. However, if they elect to take installments rather than a lump sum, then they may be taxed on any interest that is earned on the account balance.
4 ways to protect your inheritance from taxes
You just learned that your inheritance might be exposed to not just one, but three different types of taxes. On top of that, some of them are taxed at both the state and federal level. Because of this, perhaps you’re interested in finding out ways you can protect your inheritance as much as possible. After all, you don’t want your hard-earned legacy to be eaten up by taxes.
Here are 4 ways to protect your inheritance from taxes:
1. See if the alternate valuation date will help
For tax purposes, the estates are evaluated based on their fair market value at the time of the decedent’s death. However, you also have the option of selecting the alternate valuation date, which is 6 months after the decedent’s death. This option becomes available in the case that the estate valuation will be less, thus helping lower the gross value and tax liability. Any property sold within this 6-month period is valued on the date of the sale instead of the date of death.
2. Transfer your assets into a trust
If you are planning on creating an inheritance, consider placing your estate into a trust. A trust is an estate planning document that works in tandem with a last will and testament. You transfer your assets into the ownership of a trust, which is not considered an individual.
One of the main benefits of a trust is being able to pass on assets to your beneficiary without going through probate. This helps protect your privacy and shelter you from expensive fees. Further, irrevocable trusts can protect your estate from estate and income taxes.
3. Minimize IRA distributions
Retirement accounts are one of the most common types of assets that are included in an inheritance. Distributions from IRAs are taxable, except for Roth IRAs. A spouse can typically spread the distributions over his or her lifetime. However, most other beneficiaries have 10 years to distribute the account.
One way to minimize IRA taxes is a Roth conversion. A financial professional can provide an analysis whether this is a viable option for you.
4. Make charitable gifts
This might seem counterintuitive at first but making sizeable gifts and donations can help lower your overall tax liability. You’ll also feel good by giving to those in need. In 2023 you can give gifts in the amount of $17,000 without being subject to gift taxes.2 This means that you could also opt to make small gifts to each of your beneficiaries each year before you pass away, thus helping lower your overall taxable amount.
Next steps for you
As this guide demonstrates, you might get lucky and get away with little to no taxes. On the other hand, if you have a large estate, then you might owe quite a lot. Understanding tax implications is an important aspect of inheritance and estate planning. One of the most popular strategies for protecting your assets from taxes is to place them into a trust.
- If you’re interested in setting up a trust in tandem with your will, Trust & Will offers informative estate planning guides to help you find the right option.
- To invest with your loved ones in mind, consider using Empower’s wealth management services.