Do You Pay Taxes On Inheritance?
Readers interested in the tax consequences of an inheritance likely fall into one of two categories: Those who are expecting to inherit money from an older relative or those planning to pass their own wealth down to loved ones. In either case, there's nothing selfish or greedy about being concerned with the tax obligations of bequeathing money; that's just smart. Right away, the good news is that inheritances aren't typically subject to taxes at the federal level unless they're quite large.
More specifically, when we discuss taxes on an inheritance, there are really four different types of taxes in play: estate taxes, inheritance taxes, capital gains tax, and income tax. While estate taxes and inheritance taxes may seem similar, there's a crucial difference. Estate tax is deducted from a person's estate upon their death before the estate is distributed to beneficiaries. Inheritance tax, on the other hand, is paid by the beneficiary — that is, the person inheriting the estate — once they receive the inheritance.
Capital gains tax, as you might already know, is applied to the profit resulting from the sale of an asset or investment. In the case of inheritances, capital gains tax only applies to the portion of profits logged after you've already inherited the asset(s). As for income tax, with reference to inheritances, this tax typically only applies to distributions taken from a pre-tax retirement account, like an IRA. Confused yet? Let's now take a deeper look at each type of tax.
Estate taxes
With regard to estate taxes on an inheritance, the average family isn't likely to be taxed unless the estate is excessively large. For 2024, for example, estates up to $13,610,000 are completely exempt from federal estate tax. Even if the amount in question is greater than $13.61 million, federal estate tax is progressive — with brackets like income taxes — ranging from 18% to 40%. For example, an estate exceeding the exempt amount by $1 million or more (so $14,610,000 or more total estate size) will be subject to a fixed base rate of $345,800, plus 40% of the amount that's in excess of $13.61 million. That example represents the maximum tax exposure.
Though the federal threshold for paying estate tax is quite high, a handful of states also have an estate tax on a state level and some states do tax estates that are much smaller than the federal level of $13.61 million. The states that have estate taxes include Connecticut, the District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.
Terms vary widely by state, but the minimum estate size that triggers a state tax is $1 million (Oregon) and goes up to match the federal threshold of $13.61 million (Connecticut). State tax rates on estates vary from 0.8% up to a maximum of 20%. If you or your loved one lives in one of the states listed above, you can view that state's exact policies at the Tax Foundation website.
Inheritance tax
Beginning on a positive note, there's no federal inheritance tax — regardless of the value of the estate. Six states (soon to be five), though, do levy an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Note, Iowa is phasing out its inheritance tax and will eliminate it altogether for deaths happening January 1, 2025 or later. Meanwhile, as a beneficiary living in a state with an inheritance tax, there isn't much you can do after your loved one has died. However, the person leaving an estate to you can take measures to minimize exposure to state inheritance tax.
Money Digest recommends contacting a qualified tax professional for advice on minimizing tax obligations, but one common strategy is for the person leaving money (which can be in the form of cash, stocks, bonds, and more) to gift it away while still alive, because typically, gifts aren't taxed by most states. To view the relevant rates for states that do levy inheritance tax, again, visit the Tax Foundation.
Capital gains tax
Capital gains tax is a federal or state tax that's charged when assets are sold at a profit. You might already be familiar with capital gains tax from buying or selling stocks, mutual funds, or real estate investments. Fortunately, when you inherit an asset, it's subject to what's called a stepped-up cost basis. What that means is that if your wealthy uncle leaves you $100,000 worth of stock, it doesn't matter what that uncle paid for the stock when they bought it. Even if your relative paid $25,000 for shares of stock worth $100,000 at their time of death, there's no capital gains tax due on that price appreciation.
However, once the beneficiary receives the asset, the cost basis resets. If that $100,000 worth of stock is sold for $150,000 months or years later, the beneficiary will owe short-term or long-term capital gains tax on the $50,000 profit, just as if they had purchased the asset for $100,000. Short-term capital gains tax, which applies to assets held exactly one year or less, is taxed at the same rates as regular income. Long-term capital gains tax, applicable for assets held for longer than one year before selling, is levied at 5%, 10%, or 20%, depending on your income tax bracket.
Income taxes
When it comes to inheritances, you might not immediately consider income taxes. Yet, if pre-tax retirement accounts like an IRA are handed down, it's a real concern. If you inherit such an account and either cash it out entirely or begin to take distributions, those withdrawals will be treated as regular income and taxed as such.
There are some positives to inheriting a retirement account, however. For example, in the case of IRAs, there's no penalty for early withdrawal, even if the beneficiary hasn't reached 59 1/2 years of age. The flip side is that a beneficiary will typically have a fixed period of time to remove all of the money from the account — perhaps sooner than is needed based on their financial situation. Some exceptions exist, but beneficiaries usually have 10 years to fully cash out an inherited retirement account and the payments are taxable like income, as mentioned.
If you don't need/want to use the funds immediately, an alternative is to move the assets from the deceased's account into your own newly created IRA, called an inherited IRA. Also, a separate set of more flexible rules exist if the beneficiary is a spouse. And finally, note that distribution payments from Roth IRAs aren't taxable as the money was taxed when it was deposited into the account. There are many nuances to inheriting a retirement account from a loved one and as always, Money Digest recommends consulting with a qualified tax expert or financial planner.