Are you going to inherit something from someone you were close to? Are you wondering what your inheritance tax liability will be once you inherit it? Do you want to ensure that you are following all the taxation rules as laid down by the taxation authorities?
If your answer to all of these questions is yes, then this article is perfect for you.
An inheritance tax is a tax paid by a person who inherits money or property from a person who has died. The person who inherits the assets pays the inheritance tax, and rates can vary based on the size of the inheritance as well as the inheritor's relationship to the deceased.
However, to help you have a complete understanding of inheritance taxes in the USA, this article will cover the following topics:
- What is Inheritance Tax?
- Differentiate between Inheritance Tax and Estate Tax
- What is the Federal Inheritance Tax Rate?
- Do Beneficiaries Have to Pay Taxes on Inheritance?
- Is an Inheritance Taxable?
- How are Inheritance Taxes Calculated?
- What are the Inheritance Tax Thresholds?
- Exemptions to the Inheritance Tax
- How to Avoid Inheritance Tax?
- Watch Out for Capital Gains Tax
- FAQs about Inheritance Taxes in the USA
- How can Deskera Help You?
- Key Takeaways
- Related Articles
What is Inheritance Tax?
Inheritance tax is a tax that is levied on the transfer of property or assets from a deceased person to their heirs or beneficiaries. This tax is typically assessed at the state and/or federal level, depending on the laws of the jurisdiction where the deceased person lived and where their assets are located.
The purpose of inheritance tax is to generate revenue for the government and to ensure that the distribution of wealth is fair and equitable. The tax is typically calculated as a percentage of the total value of the estate, with higher rates applying to larger estates.
There are several factors that can influence the amount of inheritance tax that is owed. These include the size of the estate, the relationship between the deceased person and their beneficiaries, and the tax laws in the jurisdiction where the estate is being administered.
In the United States, the federal estate tax applies to estates valued at more than a certain amount (currently $11.7 million for individuals and $23.4 million for married couples) and is subject to a top rate of 40%. However, many states also have their own estate tax laws, which may have different exemption thresholds and tax rates.
It's important to note that not all property or assets are subject to inheritance tax. For example, assets that are jointly owned by a married couple or held in a living trust may not be subject to tax upon the death of one of the owners. Additionally, certain types of property, such as life insurance policies and retirement accounts, may be exempt from inheritance tax under certain circumstances.
In conclusion, an inheritance tax is a tax that is levied on the transfer of property or assets from a deceased person to their heirs or beneficiaries. The tax rate and exemptions vary depending on the jurisdiction and the size and nature of the estate.
Differentiate between Inheritance Tax and Estate Tax
Inheritance tax and estate tax are terms that are sometimes used interchangeably, but they actually refer to two different types of taxes that are levied on the transfer of property or assets from a deceased person to their heirs or beneficiaries.
An estate tax is a tax that is levied on the total value of a person's estate at the time of their death before any assets are distributed to their beneficiaries. The estate tax rate is based on the total value of the estate and can be quite high, with a maximum federal estate tax rate of 40% for estates valued over $12.92 million for individuals and $25.84 million for married couples in 2023.
Inheritance tax, on the other hand, is a tax that is levied on the assets that are received by the beneficiaries of an estate. The tax rate is typically based on the value of the inherited assets and the relationship between the deceased person and their beneficiaries. Inheritance tax is not imposed at the federal level in the United States, but some states do have inheritance tax laws.
One key difference between estate tax and inheritance tax is the timing of the tax liability. With estate tax, the tax is calculated and paid before any assets are distributed to the beneficiaries, while with inheritance tax, the tax liability is calculated and paid by the beneficiaries after they receive the inherited assets.
Another difference is the way the taxes are calculated. The estate tax is based on the total value of the estate, while the inheritance tax is based on the value of the inherited assets. Inheritance tax rates can vary depending on the value of the assets and the relationship between the deceased person and their beneficiaries.
What you must also keep in mind is that considering that estate tax and inheritance tax are different, occasionally, some might be hit by both. The state of Maryland, for instance, levies both an estate tax and an inheritance tax, which means that an estate may be required to pay both the IRS and the state before the beneficiaries may be required to pay the state once more out of any remaining funds. This isn't typical across the nation, though.
It's important to note that the rules and regulations surrounding estate and inheritance tax can be complex and may vary depending on the specific circumstances. Consulting with a qualified tax professional or estate planning attorney can help you to understand the tax implications of an estate and how to minimize the tax liability for your beneficiaries.
What is the Federal Inheritance Tax Rate?
There is no federal inheritance tax, which is a charge on the total amount of assets a person inherits from a decedent. In contrast, a federal estate tax is imposed on estates that are worth more than $12.92 million in 2023.
Only the portion of an estate that exceeds such sums is subject to tax. The rate ranges from 18% to 40% on a sliding scale.
Do Beneficiaries Have to Pay Taxes on Inheritance?
It depends on their kinship to the deceased as well as the jurisdiction in which the deceased resided or possessed property. Inheritance taxes can only be levied on assets that are situated in one of the six states that do so.
Inheritance taxes are never levied on surviving spouses.
Depending on the state, different immediate family members, such as the deceased's parents, children, and siblings, are exempt in differing degrees. They can be eligible to receive a certain amount tax-free as well as a reduced tax rate on the remaining amount.
More distant relatives and unrelated heirs are the main groups affected by inheritance taxes.
Is an Inheritance Taxable?
Usually, inheritances can be taxable, especially if they are passed down to you from someone who is not an immediate family member.
The taxability of inheritance depends on several factors, including the type of property or asset being inherited, the value of the inheritance, and the tax laws of the jurisdiction where the inheritance is being received.
In the United States, inheritance itself is not considered taxable income for the beneficiary. This means that the recipient of an inheritance does not have to report the inheritance as income on their federal income tax return.
However, some types of property or assets that are commonly inherited may be subject to income tax or capital gains tax. For example, if the inherited property generates income, such as rental income or dividends, the beneficiary may be required to pay income tax on that income. If the inherited property is later sold, the beneficiary may also be subject to capital gains tax on any increase in value since the original owner acquired the property.
In addition, some states may have their own inheritance tax laws that apply to certain types of property or assets. In these cases, the beneficiary may be required to pay inheritance tax on the value of the inheritance, depending on the size and nature of the estate and the tax laws of the state in question.
In the USA, only six states actually impose this tax. These are:
- New Jersey
However, what you must note here is that in 2021 Iowa passed a bill to begin phasing out its state inheritance tax, eliminating it completely for deaths occurring after January 1, 2025.
It's important to consult with a tax professional or attorney to understand the tax implications of any inheritance you receive, as the rules and regulations surrounding inheritance tax can be complex and vary depending on the specific circumstances.
How are Inheritance Taxes Calculated?
If due, an inheritance tax is applied only to that portion of the inheritance that exceeds an exemption amount. Usually, above those thresholds, tax is assessed on a sliding basis. Typically, the rates begin in single digits and rise to between 15% and 18%.
Kentucky, for example, imposes a rate that ranges from 4% to 16%, rising as the inheritance amount does, from $1,000 to over $200,000. It also imposes a flat dollar figure, ranging from $30 to $28,670, based on the sum inherited.
What you must keep in mind is that the exemption you receive, as well as the inheritance rate that you are charged, will vary more based on your relationship with the deceased than with the value of assets that you are inheriting.
The general rule is that the closer the familial relationship you have with the deceased, the higher exemption you will receive, and also, you will have to pay a lower inheritance rate.
What are the Inheritance Tax Thresholds?
In most of the states of the USA, inheritance tax applies only above a certain amount. In a few cases, however, the size of the estate is significant.
- In Iowa, if estates are valued below $25,000, then when the property passes on to the recipients, no tax will be due.
- In Maryland, all estates valued below $50,000 are exempted from inheritance tax.
In addition to their valuations, further exemptions are available for heirs based on how closely related they were to the deceased.
Here are the details of the same for which state:
- Iowa- Spouses, lineal ascendants (parents, grandparents, and great-grandparents), and lineal descendants (children, stepchildren, grandchildren, and great-grandchildren) are exempt; charities exempt up to $500. The tax rate on others ranges from 3% to 9% of inheritance in 2022.
- Kentucky- Immediate family members (spouses, parents, children, siblings) are exempt; other recipients are exempt up to $500 or $1,000. The tax is on a sliding scale based on the size of the inheritance and includes a minimum amount plus a percentage ranging from 4% to 16%.
- Maryland- Immediate family (parents, grandparents, spouses, children, grandchildren, siblings) and charities exempt; other recipients exempt up to $1,000. The tax rate is 10%.
- Nebraska- Spouses and charities are fully exempt; immediate family (parents, grandparents, siblings, children, grandchildren) are exempt up to $40,000 (rising to $100,000 in 2023). Other relatives are exempt up to $15,000 ($40,000 in 2023) and unrelated heirs up to $10,000 ($25,000 in 2023). Prior to 2023, the tax rates above those exemptions are 1%, 13%, and 18%, respectively. Starting in 2023, those rates will rise to 1%, 11%, and 15%, respectively.
- New Jersey- Immediate family (spouse, children, parents, grandparents, grandchildren) and charitable organizations are exempt. Siblings and sons/daughters-in-law are exempt up to $25,000. The tax rate ranges from 11% to 16%, depending on the size of the inheritance and the familial relationship.
- Pennsylvania - Spouse and minor children exempt. Adult children, grandparents, and parents are exempt up to $3,500. The tax rate is 4.5%, 12%, or 15%, depending on the relationship.
Exemptions to the Inheritance Tax
In the United States, both the federal government and many states have estate tax or inheritance tax laws. These laws typically provide for exemptions from the tax, which can significantly reduce or eliminate the tax liability for the estate and beneficiaries. Here are some of the common exemptions that may be available:
- State-level exemptions: Many states have their own estate tax or inheritance tax laws, and the exemptions and rules can vary widely. Some states have higher exemption thresholds than the federal government, while others have lower thresholds or no exemptions at all. In some cases, state laws may provide additional exemptions for certain types of property or assets.
- Spousal exemption: Spouses are generally exempt from federal estate tax on any inheritance they receive from their deceased spouse. This means that if one spouse dies, the surviving spouse can inherit any amount from the estate without incurring federal estate tax liability. Also, in New Jersey, domestic partners are exempted too.
Note: Sometimes, the children of the spouses are also exempt. In fact, descendants are only subject to an inheritance tax in Pennsylvania and Nebraska.
It's important to note that the rules and regulations surrounding inheritance tax can be complex and may vary depending on the specific circumstances. Consultation with a qualified tax professional or estate planning attorney can help you to understand the exemptions that may be available and how to take advantage of them.
How to Avoid Inheritance Tax?
There are a few strategies for reducing the tax burden on passed-down assets. Giving away assets before passing away is a regular aspect of estate planning, and seeking assistance from a skilled tax professional might be essential. A lot of states do not tax gifts. Remember that presents don't have to be in cash; they can also be in the form of stocks, bonds, automobiles, or other assets.
Once they have inherited an estate, beneficiaries are limited in their ability to avoid inheritance taxes. Yet, those who are leaving the estate might take measures in advance to guarantee that beneficiaries are in the best circumstances. These estate-planning tools include:
Grantor Retained Annuity Trusts
A GRAT is an irrevocable trust that enables the trust's creator, also referred to as the grantor, to designate specific assets into a temporary trust and freeze their value. By doing this, additional appreciation is removed from the grantor's estate and given to heirs with little to no estate or gift tax liability.
The assets transferred into the GRAT are regarded as being returned to the grantor because the trust pays an annuity to him or her during the duration of the GRAT. The GRAT can avoid any gift taxes by using this feature. Any remaining assets (including any increase in those assets) may then be transferred to beneficiaries, hence minimizing the grantor's estate and the future effect of estate taxes.
The estate planning mechanism known as a living trust has several uses. You and your family can use it to get ready for the future. It could assist your estate and your heirs in avoiding the inconvenience and expense of probate. Furthermore, it can protect your privacy.
A living trust, like all trusts, is a legal arrangement whereby the grantor retitles particular personal assets in the name of the trust (a different legal entity) and appoints a trustee to manage those assets in accordance with the grantor's instructions and make decisions in the grantor's and any beneficiaries' best interests.
The grantor of a simple living trust typically serves as the trustee but may also designate a co-trustee or successor. The assets eventually will pass to the trust's beneficiaries.
An irrevocable trust is one that the creator, also referred to as the grantor, cannot alter or revoke. Despite the fact that exceptions can occasionally be made, there is no simple solution because either all trust beneficiaries must agree to the modification or a court order is required.
The donor contributes assets to the trust and names a different person to serve as trustee. The grantor relinquishes all ownership rights and gives the trustee control over the assets as soon as they are transferred into the irrevocable trust. These possessions are eliminated from the taxable estate of the grantor.
Life Insurance Policy
This is one of the most common strategies, wherein you buy a life insurance policy for the sum that the grantor or creator wishes to give. Then he or she makes the beneficiary of the policy the person to whom they want to leave that amount. The death benefit from an insurance policy is not subject to inheritance taxes.
Watch Out for Capital Gains Tax
If you sell inherited assets that have appreciated in value, you can be subject to capital gains tax.
The profit you make is one factor that determines the capital gains tax rate. You might have to pay capital gains tax on the $150,000 gain if, for instance, your father left you a stock portfolio with a value of $200,000 on the day he passed away, and you sold it all for $350,000 two years later.
Certain inheritances may also result in taxable income. For instance, the payouts you take from an inherited IRA or 401(k) may be taxed.
It's a good idea to obtain professional counsel because states may have their own capital gains tax regulations.
Note: You should also consider strategies to reduce your capital gains tax.
FAQs about Inheritance Taxes in the USA
- What is an inheritance tax?
An inheritance tax is a tax that is imposed on the transfer of assets from a deceased person to their heirs. The tax is based on the value of the assets being transferred.
- Does the federal government impose an inheritance tax?
No, the federal government does not impose an inheritance tax. However, there is a federal estate tax that applies to estates that exceed a certain value.
- Which states have an inheritance tax?
As of 2021, only six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
- Who is responsible for paying the inheritance tax?
The person responsible for paying the inheritance tax depends on the laws of the state where the deceased person lived. In some cases, the estate is responsible for paying the tax, while in other cases, the heirs are responsible.
- How is the value of the assets being transferred calculated for tax purposes?
The value of the assets being transferred is usually calculated based on their fair market value at the time of the deceased person's death.
- Are all types of assets subject to the inheritance tax?
No, not all types of assets are subject to the inheritance tax. The specific types of assets that are subject to the tax depend on the laws of the state where the deceased person lived.
- What is the maximum inheritance tax rate?
The maximum inheritance tax rate varies depending on the state. In some states, the rate can be as high as 16%.
- Are there any exemptions to the inheritance tax?
Yes, there are usually exemptions to the inheritance tax. These exemptions can include certain types of property, such as a family home, as well as exemptions for certain types of heirs, such as spouses.
- Can the inheritance tax be avoided?
In some cases, it may be possible to avoid or minimize the inheritance tax through careful estate planning. However, the specific strategies that are available depend on the laws of the state where the deceased person lived.
- Do I need to pay income tax on my inheritance?
In most cases, no, you do not need to pay income tax on your inheritance. However, you may be subject to income tax on any income that the inherited assets generate, such as rental income or interest income.
How can Deskera Help You?
Deskera Books is an online accounting system that will automate several of your accounting tasks, including calculation, payment, and reporting of taxes. Thus, accounting and filing not only becomes a lot easier but also more efficient, thereby saving you from penalties.
Deskera Books will not only keep all your financial records, statements, data, and reports in one place, but it will also let you give access to your account to your accountant or tax professional by sending them an invite link.
In fact, Deskera Books comes with pre-configured tax codes, charts of accounts, and even accounting rules as needed to be followed in the USA. This will thus ensure that you are accurately calculating your federal income tax liabilities. It will also help you in fulfilling all the required forms and adhere to the deadline for it all.
Lastly, through the dashboard of Deskera Books, you will be able to monitor your financial analytics.
An inheritance tax is a tax that is imposed on the transfer of assets from a deceased person to their heirs. The tax is based on the value of the assets being transferred, as well as the closeness of the familial relationship with the deceased.
In the USA, inheritance taxes are imposed only in the following six states:
- New Jersey
While inheritance taxes mostly apply to distant relatives or others who had no connection to the dead. While spouses are always exempted, frequently even the immediate family—parents and children are exempted.
If they are taxed at all, siblings, grandkids, and grandparents are given preferential treatment (larger exemptions, lower rates). Even so, relatively tiny inheritance amounts—sometimes as low as $500—can trigger inheritance taxes.
Thus some of the ways in which you can avoid or reduce your inheritance taxes are:
- Grantor Retained Annuity Trusts
- Living Trusts
- Irrevocable Trusts
- Life Insurance Policy
Using Deskera Books will help you keep track of your inheritance tax and tax liabilities while also giving you reminders for its timely payments, thus saving you from penalties.