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:

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

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:

• Connecticut
• Hawaii
• Illinois
• Maine
• Maryland
• Massachusetts
• Minnesota
• New York
• Oregon
• Rhode Island
• Vermont
• Washington
• 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