It’s been said that there are two certainties in life: death and taxes. In some cases, they occur at the same time. If you’re preparing to leave a legacy, or if you think you stand to inherit money, it can be natural to wonder how an inheritance is taxed.
The good news is you won’t owe any tax in many cases. But, depending on a variety of factors, including what’s being passed down, how much it’s worth and where you live, you may have to cut a check to Uncle Sam.
Here are some key tax considerations when it comes to an inheritance.1
The estate tax, as the name implies, is charged to the estate of someone who leaves money behind. The federal government charges a 40 percent estate tax when wealth is passed between generations. The good news is the U.S. currently has an $11.4 million-dollar estate and gift tax exemption, which means most estates won’t owe any federal estate tax. The tax will only be levied on the portion of the estate’s value that exceeds the $11.4 million exemption. That exemption applies to individuals, which means a couple gets double that amount. And speaking of couples, a husband and wife are completely exempt — you could leave $100 million to your spouse without owing an estate tax.
While you must have significant wealth before you will owe federal estate tax, your home state’s tax laws may be a different story. While some states don’t have an estate tax, others do. And each state that has one has different rates and exemptions. Massachusetts and Oregon, for instance, currently charge an estate tax if an estate is worth more than $1 million.
Unlike the estate tax, which taxes the estate of the person who has passed away, inheritance tax imposes tax on the person receiving the money. There is no federal inheritance tax, but several states have one. Maryland charges both an estate and an inheritance tax.
The tax rates and exemptions vary greatly between the states. Here is a list of how each state taxes estates and inheritances.
Another tax consideration with an inheritance is retirement accounts. Even if you’re exempt from estate or inheritance tax, it’s possible that you’ll owe taxes on certain inherited retirement accounts. That’s because qualified retirement accounts like traditional 401(k)s or IRAs have never been taxed. Heirs who receive these accounts typically must take distributions (make withdrawals) from them and pay taxes on the distributions. How much you’re required to withdraw depends on several factors, including how much is in the account and whether the person who passed it on had already started taking distributions.
Again, when it comes to spouses, different rules apply. A spouse can retitle a retirement account if they were listed as the designated beneficiary — basically making it their own, which allows them to take distributions based on their own situation. They could also opt to take distributions based on when the deceased owner would have reached 70 ½, the age at which a retirement account owner must start taking required minimum distributions (RMDs).
INHERITANCE BASIS STEP-UP
When investments are inherited, there’s some good news from a tax perspective. Many inherited investments typically receive what’s known as a step-up in basis. Here’s how it works. Let’s say you buy investments for $10,000 (which is your basis). If you sold the investment for $19,000, you would owe tax on $9,000 (your gain). But if you pass away and leave the investment to an heir, that person will get a step-up in basis to $19,000 — the amount you pass on. That means they can sell the investment for $19,000 without owing any tax. Note, not all assets get this basis step-up, as it could vary on the asset type and how the asset is owned.
While these are the general rules around how an inheritance is taxed, this is a complicated area of tax law. If you’re in a situation where you or your estate may owe taxes on an inheritance, there are numerous strategies you can use to reduce your tax burden. A qualified financial advisor and estate attorney can help you build a plan to minimize taxes and maximize the inheritance that gets passed on.
1 State and federal tax laws are subject to change. You should consult tax and legal advisors regarding your particular circumstances.