Will I have to pay taxes on my inheritance?
"Are There Any Taxes Due On An Inheritance?"
This is a question we hear all the time, which makes sense, since the answer can be complicated.
The type and amount of taxes you pay (if any) depends on the asset you inherit and the details of the estate.
“Inheritance tax,” “death tax,” and the “estate tax” are all terms which refer to the tax due on the transfer of assets to an heir or beneficiary after an estate owner dies. But they are not exactly the same things.
Let’s take a look at the differences.
The Estate Tax: The estate tax is a transfer tax that is paid by the estate based on the total value of the assets in the estate. There are two types of estate taxes, Federal and State.
Federal Estate Tax: As of 2022, the federal estate tax is only charged when an estate is valued at $12,060,000 or more. This is called the federal estate tax exemption, any estate under this amount does not pay any federal estate taxes. This exemption is per person and can be “carried” over to their spouse, so that married couples, for instance, would have a $24,120,000 exemption.
Estate Taxes By States: Most states have a coupled tax rate with the federal estate tax — meaning that the exemption amount is the same at the state and the federal levels ($12,060,000). However ME, VT, CT, MA, RI, NY, NJ, MD, TN, IL, MN, OR, WA, and HI each have their own exemption amount and tax rate, ranging from the most taxed (NJ) with an exemption of only $675,000 to HI, which is $5,490,000.
Inheritance Tax: The inheritance tax is tax charged to the recipient of the estate. This tax is only charged by 6 states: PA, NJ, MD, KY, IA and NE. Inheritance tax is typically charged on every dollar inherited, and only the surviving spouse and minor children are exempt.
Death Tax: The death tax is just a popular term used to describe any number of taxes one might encounter as the recipient of an inheritance.
Other examples of death taxes include:
Capital Gain Tax: This is the tax you pay on the gain of an asset. When you inherit property, you receive a step up in basis in all assets to the date of death valuation. So if you sell an inherited asset, only the change from the date of death value to the sale value will be taxed.
Let’s say your mom passed away and left you the family home. The amount of money that your mom originally paid for the home is not important. From a tax perspective, what matters is the fair market value of the home at the date of her death.
Let’s break it down:
If mom paid $100,000 for the home 40 years ago, but the home is worth $400,000 the day she died, and you sell the home three months after she died for $400,000, you would pay no taxes on the sale of the home. If the home sold for $410,000, there would be a capital gain tax on the $10,000 difference (i.e. $410,000 sales price - $400,000 date of death value). This would also be true if the asset was a portfolio of stock, farmland, or a collectible car.
Income Tax: If the estate earned any income (such as interest or dividends), income tax would be due if the total income of the estate was more than $600. The income tax would be either paid by the estate if the estate retained the income, or by the heirs/beneficiaries to which the income was distributed.
One common inheritance asset are Retirement Accounts. 401ks, Traditional IRAs and Annuities are different from all other assets as they are taxed as ordinary income when withdrawn (In addition to any applicable Estate/Inheritance tax). For example, if mom died and left you a 401k, that asset is taxable, but only on the money you withdraw from the account. Thus, if mom left you a $400,000 retirement account, and you withdraw $10,000 from it, the $10,000 withdrawal will be taxed as ordinary income in the year that you withdraw.
One wrinkle to note are Roth IRAs. As they are funded with after-tax dollars withdrawals from Roth IRAs are not taxed as income, unlike a traditional IRA or 401k.
Another common inheritance asset is Life insurance: Proceeds from life insurance are not subject to income tax, however may count toward the taxable estate for estate/inheritance tax purposes.
Managing end of life finances is never an easy task. If you are in charge of an estate or a will inherited from an estate, please contact us and we’ll be happy to guide you through the process.