While it’s certainly not easy to discuss estate planning, learning how to establish a trust and getting your affairs in order before death can make things much easier for both yourself and the loved ones you’ll leave behind.
That includes knowing if your state implements an inheritance tax on the assets your beneficiaries receive. Keep reading to learn more about what inheritance tax is, how it works, and how those receiving an inheritance can avoid additional taxes.
What is an inheritance tax?
An inheritance tax, also known as a hereditary tax, is a tax imposed by certain states that you pay when you inherit money or property from the estate of a deceased individual or loved one.
The taxation of an inheritance is generally based on the
- State in which the deceased lived or owned property
- Total value of the inheritance
- Beneficiary’s relationship to the deceased
The inheritance tax comes into play once the executor of the estate has finally divided the assets up and distributed them between the beneficiaries. From there, the amount of the inheritance tax is calculated separately for each individual beneficiary.
Only six states currently impose an inheritance tax, and often, many beneficiaries are exempt from paying it, even if you live in one of those states. We’ll cover this in more detail shortly.
Inheritance vs. estate tax
When it comes down to it, the key difference between inheritance tax vs. estate tax is which party is liable for the taxes.
Estate taxes are charged against the estate, regardless of which beneficiaries inherit the assets. The estate tax is then levied based on the total value of the deceased person’s property and money, excluding unified credit.
The executor of the deceased’s established trust will then be responsible for filing a single estate tax return. Once the estate tax has been calculated based on the total value of the assets, the executor will pay out the tax on the estate’s funds, typically before the distribution of assets to the beneficiaries has begun.
Meanwhile, an inheritance tax is imposed on the beneficiary who receives assets from the estate. Then the inheritance tax amount is normally calculated based on the assets received and paid by the beneficiary rather than the estate of the deceased.
Yet, before an inheritance tax is due, the value of the assets must exceed a certain annual threshold. Since many states have high thresholds, the majority of people are exempt from inheritance tax.
Is inheritance taxed at the federal and state levels?
There are no federal inheritance taxes. While inheritance taxes aren’t part of federal taxes, you might have to pay it at the state level. As of 2024, only six states currently impose an inheritance tax, and they include:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
If you think you’ll owe inheritance tax in your state, it’s important to check with your state’s tax agency to determine whether it still applies and what the threshold is.
How is inheritance tax calculated?
But how much is inheritance tax if you live in one of these states? That will depend on several factors. The rate you’re taxed at can be impacted both by the state you reside and where the deceased lived.
Then an inheritance tax is typically only applied to the portion of your inheritance that exceeds your states exemption threshold. Inheritances above the designated threshold are subject to higher inheritance taxes and assessed on a sliding scale basis with rates increasing the more you inherit.
Many states also calculate inheritance taxes based on the closeness of the relationship between the beneficiary and the deceased. And more often than not, the closer you are to the loved one who passed away, the more likely you will be exempt from paying the inheritance taxes.
Since inheritance tax rules vary by state, inheritance tax rates also vary and typically begin in the single digits and rise to between 15% and 18%. Currently, the inheritance tax range for the six states are:
Out of the six states, Kentucky, New Jersey, Nebraska, and Pennsylvania have the highest top rate percentage. Iowa ranges in the 0% – 6% and is in the process of phasing out their inheritance tax laws with a full repeal scheduled for 2025. Starting in 2025, no inheritance tax will be imposed for assets inherited from individuals who pass on or after January 1, 2025.
How is a cash inheritance taxed?
When a loved one passes and leaves you a cash inheritance, that inherited cash isn’t taxable by the government unless the estate exceeds the applicable estate or inheritance taxes.
Additionally, if the cash you receive generates income further down the line, such as investing in an interest-bearing account, subsequent earnings may be considered taxable income. Whether it’s taxable income or not relies on the subsequent earnings coming from a tax-free source.
You can always talk to a tax expert for help navigating any questions you may have about your inheritance. They can help you determine if the cash you’ve received is considered taxable income or if your cash inheritance is exempt from taxes.
Inheritance tax exemptions
Inheritance tax rates are levied upon the death of an individual’s estate or upon the transfer of assets from the deceased estate to their beneficiaries or heirs.
Compared to estate taxes, exemptions for inheritance tax apply to the size of the gift rather than the overall size of the estate. And then only estates or property located in one of the six states that impose inheritance taxes could be subject to paying inheritance tax.
Surviving spouses are exempt from all six states from having to pay inheritance taxes. So, if your significant other passes away and leaves you with a property, even if the property is located in one of the imposing states, you won’t be subject to paying any inheritance tax on said property.
Depending on the state, other immediate relatives such as parents of the deceased, children, grandchildren, and even siblings are partially or fully exempt from paying inheritance taxes. New Jersey, Kentucky, Iowa, and Maryland all fully exempt immediate relatives from having to pay. While related beneficiaries in Pennsylvania and Nebraska are subject to a partial exemption on the assets received.
There are also different rules each state has regarding how much of an inheritance is automatically exempt from taxes. For example, in New Jersey, the sibling of the deceased can inherit up to $25,000 without being subject to paying inheritance tax on the property. But, if the inheritance is above $25,000, they’ll have to pay a tax that ranges between 11% and 16%.
How to avoid inheritance taxes
Help plan for next tax season and take steps to avoid inheritance tax by giving inheritance to those special people in close relation to you. Then, depending on the relationship you had with the deceased, you may be eligible for a reduction in the amount of inheritance taxes owed or even an exemption.
Typically, beneficiaries who inherit the decedent’s property or money and have no familiar relationship with the deceased tend to pay higher inheritance taxes.
Most states exempt a spouse from inheritance tax when they inherit property from another spouse. Children and other dependents also qualify for the same exception, but often only a portion of the inherited property may qualify.
Another option to avoid inheritance taxes is to convince your loved one to give you a portion of your inheritance money annually. The limit in 2024 for an individual to gift a person and avoid paying a gift tax is up to $18,000. Married couples who have joint ownership of property can give away up to $36,000.
If you don’t have a relationship with the deceased individual, there may be other ways to avoid the taxes on your inheritance such as moving to a state that doesn’t impose inheritance taxes before you receive the inheritance.
You can also ask your relative to set up and place their assets in an irrevocable trust fund for you and the other beneficiaries that doesn’t contain an official property transfer when they pass, thus allowing you to avoid inheritance taxes.
Lastly, on top of potentially paying an inheritance tax, you could also be subject to paying capital gains tax if the assets appreciate after you inherit them. The capital gains tax rate is primarily based on the profit you make off the assets inherited. If someone leaves you assets worth $250,000 when they pass, and a few years later, you sell all the assets for $400,000, then you could be subject to capital gains tax on the $150,000 profit.
