If you are preparing to leave a legacy to your heirs in the form of an inheritance — or perhaps you stand to inherit some money from a loved one — it’s only natural to wonder about the different ways that inheritances can be taxed.
Below, we take a closer look at some commonly asked questions about inheritance taxes and what you can do to reduce your tax burden.
Are inheritances taxed?
Whether or not your inheritance is taxed, and how much it is taxed, will depend on several different factors, including:
- Which state you live in. There is currently no federal inheritance tax, and only six states tax inheritances: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. In 2021, Iowa repealed its inheritance tax and is in the process of phasing it out by 2025. Maryland charges both an estate and an inheritance tax. If you live in one of these states and receive an inheritance, you may be required to pay taxes on that inheritance.
- How much you inherit. Most states exempt inheritances up to a certain amount. If you receive an inheritance under the exempt limit, you may owe nothing in taxes.
- Your relationship to the deceased individual. Spouses and children of the deceased may be exempt from paying inheritance taxes, depending on the state.
How much is the inheritance tax?
As mentioned above, the exact tax rate that you will pay on your inheritance will vary depending on where you live, how much you inherit, and your relationship with the deceased individual. Here is a look at inheritance tax rates by state:
- Iowa: 0-15 percent
- Kentucky: 0-16 percent
- Maryland: 0-10 percent
- Nebraska: 0-18 percent
- New Jersey: 0-16 percent
- Pennsylvania: 0-15 percent
Estate tax vs. inheritance tax
Inheritance taxes and estate taxes are two related, but different, means of taxing the assets of an individual who has passed away.
An inheritance tax is imposed on an individual who inherits assets from a deceased individual. Unlike the estate tax, it is paid by the inheritor at the time of inheritance. Here is a list of how each state taxes estates and inheritances.
An estate tax is a tax imposed on the estate of a deceased individual. Twelve states as well as the District of Columbia impose an estate tax. It is paid by the estate’s executor. The good news is that in 2023, the federal estate tax, which has a top tax rate of 40 percent, generally only applies to assets over $12.92 million. This 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 $12.92 million exemption. That exemption applies to individuals, which means a couple gets double that amount.
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.
Some key points to remember include:
There is a federal estate tax, but no federal inheritance tax.
States can charge an estate tax, an inheritance tax, or (rarely) both.
Not all states have estate taxes or inheritance taxes.
Other considerations with inheritance taxes
1. If you inherited retirement accounts
Even if you’re exempt from estate or inheritance tax, it’s possible that you’ll owe income taxes on certain inherited retirement accounts because qualified retirement accounts such as traditional 401(k)s or IRAs have never been taxed. Beneficiaries who receive these accounts typically must take distributions (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 73, the age at which a retirement account owner must start taking required minimum distributions (RMDs). (In 2033, the age will increase from 73 to 75, per the SECURE 2.0 Act.)
2. If you inherited a death benefit from a life insurance policy
If you are the beneficiary of a life insurance policy and your loved one dies, you will receive the policy’s death benefit. This death benefit is typically exempt from both state and federal taxes—including income taxes--but there may be some instances where taxes become required. For example, if you choose not to receive an immediate payout of the death benefit and instead opt to leave the sum with the life insurance company for a period of time, it will most likely continue to accrue interest. You may be required to pay income taxes on this newly generated interest.
3. Inheritance basis step-up
When investments and property are inherited, there’s some good news from a tax perspective: Many inherited investments 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 cost basis). If you sell the investment in the future for $19,000, you might owe capital gains tax on $9,000 (your gain). (Whether or not you’ll own capital gains tax will depend on your tax bracket.) But if you pass away and leave the investment to an heir, that person will get a “step-up” in cost basis — to $19,000, the amount you pass on. That means they can sell the investment for $19,000 without owing any tax.
Likewise, if you’re inheriting investment assets, your cost-basis essentially resets to the date of death market value of the assets, which can translate into massive tax savings.
(Note: Not all assets get this step-up, as it could vary on the asset type and how the asset is owned.)
Managing taxes on your inheritance
While these are the general rules around how an inheritance is taxed, this is a complicated area of tax law. If you are planning on leaving an estate to your heirs, or you will inherit money from a loved one, consider working with a qualified financial advisor, tax advisor, and estate attorney who can help you build a plan to minimize taxes and maximize the inheritance that gets passed on.
This publication is not intended as legal or tax advice. Financial Representatives do not render tax advice. Consult with a tax professional for tax advice that is specific to your situation.