INHERITANCE TAX: WHAT IT IS, WHO HAS TO PAY, AND HOW TO AVOID IT
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- Inheritance tax is calculated based on the value of an inherited gift.
- Spouses, children, and other close relatives are often exempt from paying the tax.
- Only six states impose an inheritance tax for 2023, and one is phasing it out.
An inheritance is usually a welcome gift. For some of the roughly 38 million Americans who live in a state with an inheritance tax, that gift could come with a tax bill.
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Here's how the inheritance tax works, including what types of property are included in the calculation and who can get out of paying it.
What is an inheritance tax?
When someone dies and their assets are given to another person, the recipient may be responsible for paying an inheritance tax to their state government. The federal government has no inheritance tax.
"An inheritance tax is imposed directly on the person who inherits," says Tracy Craig, a partner at the Massachusetts law firm Seder & Chandler, and chair of the firm's Trusts and Estates Practice Group. "Typically, the closer familial relationship to the decedent, the lower the tax rate."
Note: Several states with an inheritance tax allow exemptions for life insurance proceeds.
People can inherit a range of assets, from retirement accounts to real estate to jewelry collections. The inheritance tax is calculated based on their value.
Inheritance tax vs. estate tax
An inheritance tax is paid by the person who inherits property, while an estate tax is paid by the executor of an estate using money from the estate itself — and it's calculated before assets are divided among beneficiaries.
The estate tax basically amounts to a tax on the decedent's right to transfer property, as opposed to a tax on the privilege of receiving property.
If you live in a state that taxes inherited property, you may be able to deduct the tax you paid on your federal return, Craig says.
Here are the main differences between an inheritance tax and estate tax:
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Which states have inheritance tax?
Only six states impose an inheritance tax on beneficiaries for 2023:
- Iowa: 2% to 4%
- Kentucky: 4% to 16%
- Maryland: 10%
- Nebraska: 1% to 18%
- New Jersey: 11% to 16%
- Pennsylvania: 4.5% to 15%
In these states, an inheritance tax return typically needs to be filed to detail who received what assets and how much tax is owed, Craig says. States usually allow some of an inheritance to be exempt from taxes. In some cases, the entirety of an inheritance could be tax free.
For example, in New Jersey, inheritors are classified by their relationship to the decedent. Class A beneficiaries don't pay inheritance taxes. Class C beneficiaries — close family relatives, such as siblings, sons-in-law, and daughters-in-law — get an exemption on the first $25,000 in inherited assets. Amounts beyond $25,000 are taxed progressively, ranging from 11% to 16%.
Note: Iowa will phase out its inheritance tax by January 1, 2025.
How to avoid inheritance tax
There are a few ways to avoid triggering an inheritance tax for your heirs if you plan ahead, including gifting assets during your lifetime or placing property into a trust.
If you have substantial wealth to pass on, having your heir move to a state without an inheritance tax might be worth consideration. The tax is based on where the recipient lives.
Additionally, leaving assets to spouses and children generally avoids the inheritance tax.
Inheritance tax frequently asked questions
How much inheritance can you get without paying taxes?
Depending on the state, spouses, children, and grandchildren of the deceased are often exempt from paying inheritance tax. Other beneficiaries may get a small exemption before the tax kicks in.
How can I avoid inheritance tax?
Having your beneficiaries move to a state without an inheritance tax, gifting your assets during your lifetime, or setting up a trust are potential ways to avoid subjecting them to an inheritance tax.
Do I have to report inheritance to the IRS?
You don't have to report inherited property, such as cash or real estate, to the IRS. However, some inherited assets will need to be reported if they generate income.
Does an inheritance count as income?
An inheritance itself is not considered income for federal tax purposes, but certain earnings you collect may be. If you live in Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania, you might have to report your inheritance on your state income tax return.