Inheritance Tax: How It Works and Who’s Exempt - MagnifyMoney

Inheritance Tax: How It Works and Who’s Exempt

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Inheritance tax is a state tax charged by only six states when someone receives an inheritance from someone who has died. Unlike estate tax, which can be levied by both the federal government and states, inheritance tax comes out of the beneficiary’s pocket — not out of the estate. The rate varies depending on how much you inherit and your relationship to the deceased.

However, many beneficiaries are exempt from paying this tax. If you’re getting an inheritance, you’ll want to know whether you’ll owe inheritance tax — and if so, how much you may have to pay.

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How inheritance tax works

The federal government doesn’t have an inheritance tax — this is a state-specific levy, and it is only present in six states. As of 2021, the following are states with inheritance tax:

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

In states that have taxes on inheritance, a person who inherits money or property after someone dies may owe taxes on it. Inheritance tax only applies when the beneficiary inherits property from someone who lived in a state that has an inheritance tax. It matters only where the deceased lives, not the beneficiary.

For example, if you live in Florida and you inherit money from an uncle who lives in Kentucky, which is one of the six states that does impose an inheritance tax, you may owe inheritance taxes to the state of Kentucky. However, if you live in Kentucky and inherit assets from an aunt who lives in Florida, a state that does not have an inheritance tax, you would not owe inheritance tax.

How much is inheritance tax?

How much you’ll pay in inheritance tax can depend on multiple factors. This includes your relationship to the person who has died (also known as the decedent) and how much you inherit, as well as the laws in the state in which the decedent lived. If you inherit an individual retirement account (IRA), additional factors come into play.

State inheritance tax rates

Each of the six states that impose an inheritance tax has its own brackets and rates. The tax rate is effectively a percentage of the value of the assets you are inheriting from the decedent. Nebraska has the highest cap, at 18%, while Maryland’s is the lowest, at 10%.

StateInheritance tax rates
Iowa0% to 15%
Kentucky0% to 16%
Maryland0% to 10%
Nebraska1% to 18%
New Jersey0% to 16%
Pennsylvania0% to 15%

Inheritance tax exemptions

In some cases, certain beneficiaries are exempt from paying inheritance tax based on their relationship to the person who has died. Spouses are always exempt, meaning that if your spouse dies and leaves you all of their worldly possessions, you won’t owe any inheritance tax, no matter where you live.

Children may be exempt as well, or they may have to pay taxes on only part of the inheritance. Charitable, religious and educational organizations are also usually exempt from paying inheritance tax. There are also certain situations that may exempt someone from inheritance tax. In Pennsylvania, for instance, if a parent inherits property from a child age 21 or younger, the inheritance tax rate is 0%.

Additionally, some states offer exemptions on some amount of inheritance before taxes are due. In Kentucky, for instance, a niece or nephew of the deceased would be exempt on the first $1,000 of inheritance before owing taxes, while a cousin or non-relative would be exempt on the first $500. A spouse, parent, child, grandchild, sibling or half sibling would owe no inheritance taxes. In Nebraska, close relatives (parents, grandparents, children and siblings) are exempt on the first $40,000 of inherited assets. For other relatives, such as aunts, uncles, nieces and nephews, the exemption is lower, at $15,000, and the tax increases to 13%.

IRAs and inheritance tax

If you inherit an IRA, how much you’ll owe in taxes will depend on the situation:

  • If you inherit an IRA from your spouse: You can leave the money where it is or roll it into an inherited IRA or your own IRA, and you don’t have to take required minimum distributions unless you choose to do so. As a spouse, you owe no inheritance taxes. You may owe income taxes depending on your spouse’s age and what you choose to do with the IRA.
  • If you inherit an IRA from a non-spouse: Whether you’ll owe taxes in this situation depends on the state. You may owe inheritance tax on a traditional IRA, but in some states it will depend on whether the deceased was under age 59 ½ or over age 59 ½. It will also depend on your relationship to them. You may also (or only) owe income taxes on distributions.

“This is why I recommend making the IRA or qualified plan the first source for any charitable bequests at death, using beneficiary designations,” said Michael Whitty, a CFP in Chicago. “The charity pays no estate, inheritance or income taxes.”

Inheritance tax vs. estate tax: What’s the difference?

Inheritance tax and estate tax are very similar, in that both are assessed after someone dies. “Estate taxes and inheritance taxes are both a type of tax on the transfer of wealth,” Whitty said. However, there are key differences between the two types of taxes.

With inheritance tax, the person or organization that inherits the assets pays the taxes, and they pay only on what they inherit. Their tax rate varies depending on their relationship to the deceased. In Pennsylvania, for instance, direct descendants pay 4.5% on inheritances, siblings pay 12%, and other heirs pay 15%.

With estate tax, on the other hand, any taxes owed are paid by the estate when someone dies, and those taxes are based on the total value of the estate on the date of death. While inheritance tax is limited to only six states, estate tax can be levied by the federal government and/or states. As of 2021, 12 states and the District of Columbia impose an estate tax.

The federal government exempts estates that do not exceed $11.7 million in 2021, meaning that most people won’t owe estate taxes to the IRS when they die. At the state level, the exemption is often lower. In Oregon, for instance, the state estate tax only exempts estates that do not exceed $1 million.

Can states have an inheritance tax and an estate tax?

States can have both an inheritance tax and an estate tax, but only one does: Maryland. (The state of New Jersey used to also have both taxes, but the state repealed its estate tax in 2018.)

Having both taxes means that the estate might have to pay taxes to the IRS and to the state, and then beneficiaries might have to pay out of pocket again on any assets they inherit from the estate. That said, Maryland exempts estates of up to $5 million in value, and many direct relatives of the deceased are exempt from inheritance taxes.

How to minimize inheritance tax

One common way to reduce inheritance taxes is to give some of your estate away before you die so there’s less to inherit. Each year, you’re allowed to gift up to $15,000 to any individual before you have to worry about gift taxes. This is true for each donor and each donee, so you and your spouse could each give $15,000 to a child for a total of $30,000 per child, or you could give a combined $60,000 to an adult child and their spouse in a tax year.

You can also gift non-cash assets, such as investments or property. “This can help transfer wealth without having to be subject to the inheritance tax,” Whitty said.

Luckily, with only six states assessing an inheritance tax, there’s a good chance your loved ones won’t have to pay anything, particularly if you’re leaving everything to direct descendants (like your children). If you’re concerned about the inheritance taxes your beneficiaries may pay, a financial planner or estate attorney can help you determine the best strategy for reducing their tax burden.

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