There’s an old saying that “the only two certainties in life are death and taxes.” Ironically, though, the saying seldom applies to death and taxes. Most Americans don’t have to pay an inheritance tax when they inherit money or property. Still, there might be some complications you need to clear up if someone has included you in their will. For instance:
Perhaps chief among the complications that need to be clarified when someone dies is that there are two different types of taxes that might apply: estate taxes and inheritance taxes. Estate taxes are paid by the deceased’s estate before any money or property passes on to you, but if inheritance taxes are owed, they are paid by you, as the beneficiary. And because the first $11.4 million worth of an estate is exempt from federal estate tax1, the vast majority of Americans don’t have to pay it. There is no federal inheritance tax.
Only six states had an inheritance tax on the books in 2019:
You would only owe inheritance tax if the money or property willed to you comes from someone in one of these states. The tax kicks in at different asset levels at rates that vary, depending on the state, your relationship with the deceased, and other factors. You might pay 1% to 20% of the total value of your inheritance. Or you might not, due to exemptions and reductions for spouses and other family members.2
Looking at New Jersey, for instance, spouses, parents, children, and grandchildren are exempt from the 11%-16% inheritance tax on assets over $25,000. But siblings and the partners of deceased children would have to pay.3 In Nebraska, meanwhile, aunts, uncles, nieces, and nephews are taxed on inherited assets over $15,000 at a rate of 13%. Closer relatives such as parents, grandparents, children, and grandchildren are taxed on inheritances over $40,000, at a rate of 1%, and spouses are exempt.4
The federal government and about a dozen states have estate taxes which, as the name implies, are paid by the estate and not its heirs. Before any money or property is passed on to you, the executor of the will may have to pay estate taxes that could shrink your inheritance. But few people pay estate taxes, either.
That’s largely because of the high bar that is set before an estate tax even applies. Federal estate tax exemptions have increased from $1.5 million in 2004 to $11.4 million in 2019 and nearly $11.6 million for 2020. According to the IRS, most estates below those thresholds do not have to file an estate tax return.5 The Tax Policy Center has estimated that fewer than 0.1% of the 2.7 million Americans who died in 2018 were subject to a federal estate tax.6 In the states with estate taxes on the books, the exemption ranges from $1 million to $5.68 million.7
You may end up owing capital gains taxes if you sell inherited assets like real estate, stocks, and bonds. Federal capital gains tax is paid on whatever value you gain (or lose) when you sell a thing, compared with what you paid for it. Capital gains on inheritances are considered long-term, no matter how long you hold them,8 and so they were subject to 0%-20% tax rates in 2019, depending on your income.9 Many states have their own capital gains taxes.
Here, the important thing to know is that you calculate your gain or loss on the sale of an inherited asset based on its fair market value when the deceased died and you inherited it, not the original purchase price. This is called the “stepped-up” value. Since the profit on the sale of a house, for example, would be lower if based on the stepped-up value as opposed to the original purchase price, less tax would be owed. It might be best to consult a tax advisor or estate attorney when dealing with capital gains taxes on inheritances.
The 2019 Secure Act accelerates required minimum withdrawals/distributions from inherited IRAs (unless you’re the spouse). In the past, you could stretch the distributions and associated tax payments over your expected lifetime. As of 2020, the assets must all be withdrawn within 10 years of the death of the account holder, with taxes due for each withdrawal. A MarketWatch report concluded that, “The drain-in-10 rule can result in a large tax bill for a beneficiary, especially if that person is in their 40s or 50s, which is typically the peak earning years.” The report predicted that it will take tax advisors and estate planners some time to work through the implications of the new law.10
Few Americans pay inheritance taxes when someone wills them money or property. Nevertheless, the federal and state rules and exemptions regarding inheritance, estate, and capital gains taxes on the sale of inherited property are complicated enough to require analysis and advance planning by anyone who thinks they are coming into inherited money.
1 “Estate Tax,” IRS
2 “What Are Inheritance Taxes?” TurboTax
3 “New Jersey State Inheritance Tax,” Legal Consumer
4 “Nebraska Has an Inheritance Tax,” Legal Consumer
5 “Estate Tax,” IRS
6 “How Many People Pay the Estate Tax?,” Tax Policy Center
7 “Does Your State Have an Estate or Inheritance Tax?” Tax Foundation
9 “Long-Term Capital Gains Tax Rates in 2019,” Motley Fool