The Comprehensive Guide to Inheritance Tax

by | Apr 23, 2020

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Research shows that one in three Americans expect to receive a significant inheritance at some point in their lives. 

While receiving money, real estate or valuables from a cherished loved one can be a welcome gift, there’s one element you might have overlooked: inheritance tax. 

If you’ve received a bequest from a loved one who has passed away, read on. While not everyone will have to pay taxes on this offering, it’s important to know where you stand and what your requirements include.

Today, we’re diving into some of the most common questions regarding the inheritance tax to clear up any confusion and set the record straight. 

What is Inheritance Tax?

First, let’s review what inheritance tax includes.

This is a state-level tax enacted on the assets and properties that a beneficiary receives after someone dies. If you’ve inherited (or plan to inherit) something from anyone who lived in those qualifying states, your inheritance could be subject to state inheritance taxes. Note that the state of residence only applies to the person who passed away, and not the heir.

Even if you currently live in one of those six states, if the person who died lived in any of the remaining 44 states, you do not have to pay state inheritance taxes. To better understand how inheritance tax works, let’s review a few similar taxes that fall under the “death tax” category.

Capital Gains Tax

Capital gains tax is a tax you could incur if you sell a non-inventory asset that you inherited from someone else. The tax will be placed on the proceeds you make from the sale. Examples of non-inventory assets include:

  • Real estate
  • Property
  • Stocks
  • Bonds
  • Precious metals

In addition, any distributions you take from an inherited IRA or 401(k) could be eligible for capital gains tax. Moreover, if you inherit real estate, the IRS will assign it a Fair Market Value (FMV) that will influence your future taxes when and if the property sells. While these costs might add up, the silver lining is that they aren’t nearly as imposing as income-based tax brackets.

We’ve discussed that individual states determine inheritance tax regulations. However, the federal government is typically only concerned about any capital gains tax you might owe. It does not include your inheritance as part of your federal income tax.

Estate Tax

Estate tax and inheritance tax are often used interchangeably, though they are two different terms. 

Estate tax is a levy on the personal estate of a person who has died. In short, it is a tax on a person’s right to transfer their entire estate ownership to a loved one. Unlike inheritance tax, it is not paid by the heirs, but by the estate itself. 

Before the assets are distributed to beneficiaries, any required estate tax is levied and paid from the deceased person’s assets.

What makes a particular property liable for estate tax charges? The answer lies in the value of the property.

Every year, the Internal Revenue Service (IRS) releases official estate and gift tax limits. In 2020, those values are higher than in years past. This year, the estate and gift tax exemption is $11.58 million for individuals and $23.16 million for married couples (doubled). This is an increase from $11.4 million for individuals in 2019.

This means that someone can leave up to those monetary limits to their heirs and avoid paying federal estate tax on that amount. However, if the amount bequeathed exceeds those limits, the property can become subject to taxation at a rate that can climb as high as 40%. In this case, the executor of the deceased person’s will must file a federal estate tax return within 90 days 

As these property values are so high, most people will not need to worry about falling above the threshold. In addition to federal exemption limits, individual states can impose their own estate taxes and limitations. For instance, the New York estate tax can range between 3.06% and 16%.

Is Inheritance Taxable?

As mentioned, the federal government doesn’t consider inheritance as part of your taxable income. However, states follow different regulations. A small portion will require you to pay state inheritance tax on the assets you receive after a loved one’s death. These can vary based on how each heir was related to the deceased.

Once the executor has finished dividing up the estate and distributing them among the beneficiaries, the inheritance tax will be levied. Then, you’ll report your inheritance on an inheritance tax form. In your research, be sure to pay attention to the state-imposed income limits concerning inheritance tax. 

For instance, say you receive $100,000 from your parents, but the state they lived in only imposes a 5% tax on inheritances over $50,000 million. In that case, your only taxable inheritance would be the excess $50,000.

What States Have Inheritance Tax?

Wondering if you’ll be required to pay inheritance tax this year? The six states the currently impose the tax include:

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

Next, let’s see how much you can expect to pay if you’re inheriting something from a loved one in any of those states. 

How Much is Inheritance Tax?

Each of the six participating states has its own set of guidelines dictating inheritance tax. The amounts are imposed as ranges. The ranges are as follows:

  • Iowa: 5% to 15%
  • Maryland: 10%
  • Nebraska: 1% to 18%
  • Kentucky: 4% to 16%
  • New Jersey: 0% to 16%
  • Pennsylvania: 4.5% to 15%

Understand that these tax ranges are subject to change from one year to the next. Moreover, states could join or leave this list at any time. For instance, Indiana used to enact an inheritance tax up until 2013.

Does a Spouse Pay Inheritance Tax?

Regardless of what you leave your surviving spouse when you die, anything he or she inherits is considered tax-free. There is no limitation or cap on spousal inheritance. This means that if your spouse passes away and leaves you with a piece of valuable property, you won’t have to pay inheritance tax, even if that property is located in one of the six states above. 

In addition, a majority of the six states that do impose inheritance tax have exemptions for nuclear family members. For instance, Iowa does not impose the tax on the following linear relatives:

  • Spouses
  • Children
  • Stepchildren
  • Grandchildren
  • Great-grandchildren
  • Parents
  • Grandparents
  • Great-grandparents

Other states have similar rules and will vary their inheritance tax rate depending on the beneficiary’s relationship to the deceased. For example, in Pennsylvania, spouses, and children 21 or younger aren’t required to pay inheritance tax. However, adult lineal heirs pay 4.5% and siblings pay 12%.

Are Inheritance Taxes Deductible?

While federal estate taxes are not deductible, state-imposed inheritance taxes are deductible on your federal taxes.

Both Form 1040A and Form 1040EZ only allow you to take a standard deduction. However, your inheritance tax should be deducted as an itemized deduction. Unless you don’t have any other major deductions, you’ll need to access Schedule A on your income tax return to itemize.

If you itemize the deductions (including your inheritance tax) and find that they don’t add up to the standard deduction, you’ll save more by simply taking the standard deduction.

For 2019-2020 tax purposes, the standard deduction amounts are as follows:

  • Single filers: $12,200
  • Married filers filing separately: $12,200
  • Married filers filing jointly: $24,400
  • Heads of household: $18,350

If you do decide to itemize using Schedule A, you’ll list your inheritance on Line 8, which is labeled “Other taxes”. Label the amount as your state inheritance tax.

Does Inheritance Count as Income?

Inheritance is not counted as part of your income at the federal level. This is true regardless of whether you inherit cash, investments or any other type of property.

However, it’s important to understand that moving forward, any earnings that you make on the acquired assets will be considered taxable. For instance, you’ll have to pay tax on the interest income you receive from inherited cash in your bank account. Likewise, you’ll pay dividends on inherited stocks or bonds. The only exception would be if any earnings came from a tax-free source. 

How to Avoid Inheritance Tax

Want the benefits of your inheritance without all of the costs? There are certain ways to avoid inheritance tax.

Of course, the two most obvious ways to completely avoid the issue are to get married or convince your loved ones to move away from a state that imposes the tax. Yet, these are drastic measures! Thankfully, there are easier workarounds.

Staggered Inheritance

Instead of receiving your entire inheritance as a lump sum at your loved one’s date of death, ask if you can receive it in staggered payments while they’re still living. This is a basic estate planning tactic that can help keep all parties financially stable.

This way, they can give you a portion of the amount every year as a gift. In 2020, anyone can give a gift of up to $15,000 to another person without having to pay a gift tax. If married couples own property jointly, they can gift up to $30,000. The IRS designates this as a Unified Tax Credit.

Not only does this help you avoid getting stuck with a tax bill down the road, but it also allows your loved one to see how you spend the money and enjoy the gift with you!

Revocable Living Trusts

Alternatively, you could also request that your loved one establish a revocable living trust. This is a document that determines how someone’s assets will be handled upon their death.

Those assets can include:

  • Bank accounts
  • Real estate
  • Valuable property/possessions
  • Investments

Because it is revocable, the owner of the trust can change or alter the terms at any time. With an irrevocable trust, everyone named in the trust has to sign off on the changes before they can be enacted. While irrevocable trusts include taxes, revocable ones do not.

The owner of the trust will continue to own and pay taxes on the assets included therein. While these are two approaches to consider, an estate planning attorney can help you navigate this process most effectively.

Can You Refuse an Inheritance?

In short, yes. The term for this process is “disclaiming an inheritance” and it’s more common than you might think.

While it might seem strange to consider that you won’t want a portion of your loved one’s assets, the costs associated with claiming them might be too high. Or, there could be personal reasons why you choose to disclaim it.

While the laws and processes will vary by each state, most have clear procedures for you to follow. Most of them require you to file an irrevocable, written disclaimer that details your intention to refuse the bequest. First, you’ll sign the form and have it notarized. Then, you’ll file it with the probate court or the executor of the last will.

If there’s a contingent beneficiary listed in the will, that person will receive the inheritance instead. If the deceased person did not leave a will, the state’s laws of intestacy will determine the subsequent beneficiary.

Will an Inheritance Affect My Medicaid?

Your Medicaid eligibility is affected by three factors:

  • Your personal situation
  • Your income
  • Your assets

If your inheritance puts you over the income limits, it could render you ineligible to receive Medicaid. While each state sets its own eligibility criteria, most programs set an asset limit of $2,000 for individuals and $3,000 for couples. These assets usually exclude basics such as:

  • The house you live in
  • One vehicle
  • Your personal possessions 

In addition, most states will allow you to possess up to $1,500 in a burial fund and $1,500 in life insurance benefits. If the inheritance you receive puts you over these limits, you could be disqualified from receiving Medicaid.

In addition, note that your inheritance will be counted as income for the month that you receive it. You could also be disqualified if the amount you earn that month puts you over the Medicaid income limits for your state. If you can spend down that amount by the end of the month, you can re-qualify again the next month.

Can Debt Be Collected From My Inheritance?

Research shows that 73% of people in the United States will die with some form of outstanding debt.

The good news is that you’re generally not responsible for a deceased person’s debt. Some exceptions would be if you co-signed for a loan or credit card, own property or a business jointly or live in a community property state.

However, the lines get a little blurrier when inheritance is involved. In most cases, a person’s estate is responsible for settling their outstanding debt. In turn, there will only be an inheritance if there is enough money left in the estate to eliminate those debts.

Two major assets are exempt from any form of debt collection upon someone’s death. They include:

  • Retirement savings
  • Life insurance policies

These can be distributed to beneficiaries immediately without regard to any debts owed by the deceased. However, non-exempt assets or inheritances may need to be liquidated and used to pay off debts.

Can Creditors Take Inheritance Money?

No, your creditors cannot take your inheritance directly. They can, however, seek payment from the deceased person’s estate to cover existing (non-exempt) debts, final expenses, and other financial obligations.

If your loved one died with existing debts, those creditors have a certain time limit in which they can try to recoup those losses. This means they could sue you and demand quick payment. If this occurs, a judge could order you to pay the creditors from your share of the inherited assets. Most often, this process results in a lien against inherited real estate, or a levy against inherited bank assets.

Financial Resources and Advice You Can Trust

It’s no secret that the world of personal finance can be more than a little overwhelming. From inheritance tax and estate planning to insurance and loans, there are myriad factors to consider at all times.

Looking for guidance and advice as you navigate each step? That’s where we come in. Check out our personal finance blog for more information.

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