Inheritance tax can be concerning, but armed with the right information, tools and knowledge, you can navigate its ins and outs and likely even come out ahead. Learn how an Estate Plan can help protect what’s rightfully yours, and more importantly, preserve the inheritance you may one day eventually pass on to your loved ones.
Many people often mistake inheritance tax for estate tax and vice versa. So before diving into inheritance taxes, we’d like to clarify the differences.
One key difference between inheritance tax and estate tax is simply where the taxes are paid, at the state level or the federal government level.
Another significant difference is who’s responsible for the tax. While an inheritance tax is the responsibility of the beneficiary, estate taxes are paid for out of the estate, based on the total value of the estate, before any distributions are made to beneficiaries. In other words estate tax is a tax on assets held by a decedent at death and applies regardless of who gets assets. Inheritance tax is a tax on assets a beneficiary receives from a decedent and applies based on who the beneficiary is and what they receive.
What is Inheritance Tax?
Inheritance tax is a tax some states apply to assets passed down via an inheritance. There are a few key things to know about inheritance tax:
It’s not a federal inheritance tax– In fact from the federal standpoint, your inheritance likely won’t be considered income, and any taxes that are due would be paid by the estate before you receive anything. Most often (unless it’s an extremely large inheritance), the IRS won’t see any money from taxes on an inheritance.
Not all states have an inheritance tax – Actually, as of 2020, only six states currently impose an inheritance tax. More on which states have this tax later.
Asset and estate size can be a factor – Not all states that impose an inheritance tax have the same rules. Some states won’t charge anything if an estate or specific asset is under a certain amount.
Relationship to the deceased may have an impact – Some states waive tax altogether depending on the relationship to the deceased. For example, a spouse or biological child may not be subject to tax, regardless of the size of the inheritance.
Tax is based on where the deceased person lived, not where the beneficiary lives – If you have an aunt who lived in Iowa (which does have an inheritance tax) but you live in California (which does not have an inheritance tax), your inheritance would be subject to the Iowa inheritance tax. If the locations were reversed (you live in Iowa but your deceased aunt lived in California), you would not pay any inheritance tax, even though you personally live in a state that recognizes the inheritance tax.
If you receive an inheritance that’s subject to an inheritance tax, it would work like this: After the Executor distributes assets to beneficiaries, tax is calculated individually, based on the amount of the asset each beneficiary receives.
In some cases, there is a dollar-amount threshold that would trigger the tax. In others, the relationship may dictate (or waive) the tax.
So, let’s look at an example: In Iowa, you can expect to pay between 5 and 15 percent of your inheritance, depending on your relationship and the size of the asset. No inheritance tax is imposed if you are the spouse, parent, child, stepchild, grandparent, grandchild, great grandparent, great grandchild or any other lineal descendent to the deceased.
Which States Have Inheritance Tax?
Remember that there are currently only six states with inheritance tax laws. Each has their own individual calculations, threshold amounts, exemptions and taxable percentage. So how much is inheritance tax?
*Note: These are current state laws as of 2020. Inheritance tax laws are always changing, so it’s important to do research in advance to ensure you’re up to date.
States that have inheritance tax:
5 – 15 percent tax, depending on the size of the inheritance and the relationship to the deceased
EXEMPT: Spouses, parents, children, stepchildren, grandparents, grandchildren, great grandparents, great grandchildren
EXEMPTION THRESHOLDS: Charities up to $500
4 – 16 percent tax, depending on size of the inheritance and the relationship to the deceased
EXEMPT: Spouses, parents, children, stepchildren, grandchildren and siblings, half siblings
EXEMPTION THRESHOLDS: Up to $500 – $1000
10 percent tax, depending on the relationship to the deceased
EXEMPT: Spouses, parents, children, stepchildren, direct descendents, spouse of a child or direct descendent, grandparents, siblings or stepparent
EXEMPTION THRESHOLDS: Up to $1000
1 – 18 percent tax, depending on the size of the inheritance and the relationship to the deceased
EXEMPT: Spouses, charities
EXEMPTION THRESHOLDS: $10,000 – $40,000
11 – 16 percent tax, depending on the size of the inheritance and the relationship to the deceased
EXEMPT: Spouses, parents, civil union partners, domestic partners, children, grandparents, grandchildren, great grandchildren, mutually acknowledged children or stepchildren, schools, religious institutions, charitable organizations
EXEMPTION THRESHOLDS: Other family, up to $25,000
4.5 to 15 percent tax, depending on the relationship to the deceased
EXEMPT: Spouses, children under the age of 21, charities, any exempt institutions or government entities not required to pay taxes
EXEMPTION THRESHOLDS: Certain family members, up to $3,500
*Maryland is the only state that imposes both an inheritance tax and an estate tax, essentially potentially hitting beneficiaries twice upon an estate owner’s death.
How to Avoid Inheritance Tax
Smart Estate Planning can allow you to effectively deal with taxes on multiple levels, including any inheritance tax you may be expecting in the future or have already received. The following strategies are all proven ways to work asset protection into your Estate Plan.
Use a Trust: If you’re expecting a significant inheritance and the estate owner is still alive, consider having a conversation to suggest they set up a Trust. Trusts are excellent vehicles for asset protection and privacy, and they can drastically reduce or entirely eliminate tax liability in some cases.
Gift Money: If you plan to leave money to charities or people upon your passing anyway, you may be able to give annual gifts to future beneficiaries even while you are still living. As of 2019, the threshold for gifts without any taxes was typically $15,000 – but be aware that in some instances, gifts made shortly before passing may still be taxed. The best way to avoid a tax on gifts is to plan and give well in advance. Gifting to people or charities can reduce the size of your estate, which can reduce tax liability.
Gift Non-Cash Assets: You can give away stocks or bonds, or other assets, as well – just be sure you’re under the gift limit.
Use an Alternate Valuation Date (if possible): In some states, it may be possible to delay the date of valuation on an estate by up to six months. During that time, if estate or some asset values fall or are reduced, it might minimize the tax due, which could end up resulting in a larger inheritance.
Reduce Retirement Account Distributions: Note that there are different rules about when and how much non-spousal distributions must be on inherited retirement accounts. You’ll want to be careful about how you retitle accounts and how to best calculate the most tax-advantageous distributions.
Get Help: When in doubt, ask a CPA for advice!
An inheritance can be a blessing in so many ways. To carry on the legacy of someone you loved is an honor and can really change your life. Don’t let taxes swallow a large portion of that gift. Find out how you can best-preserve your rightful inheritance, and the inheritance you hope to one day pass down to your loved ones.