If you’re lucky enough to have inherited some assets from someone who died, you might not feel so lucky when you discover you mayowe taxes on them.
Depending on where the person who died lived, how much the assets are worth and how close you were to the deceased person, you may have to pay an inheritance tax.
Although chances are slim you'll need to pay it – the maximum value threshold is high and only six states levy that tax as of2022 – it's better to know how the inheritance tax works and whether you can avoid it.
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What states have inheritance taxes?
The six states that impose an inheritance tax areIowa,Kentucky,Maryland,Nebraska, New Jersey and Pennsylvania.
Inheritance tax only applies when the person who dies and passes on assets lived in one of those states that has an inheritance tax. It is the state where the decedent lives, and not the beneficiary, that determines if an inheritance tax applies.
The tax rates on inheritances range from less than 1% to 18% of the value of property and cash you inherit, but they can change each year so check with your state.
Iowais phasing out its inheritance tax, which will be completely abolished in that state by 2025.
New York, however, proposed bill S2782 on Jan. 24 that is introducing agift taxand tax oninherited income.
"Currently, New York does not have a gift tax," saidDana White, director at certified public accounting firm Janover. "The purpose of this proposal is to generate about $8 billion in revenue for the state."
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Do you have to pay a federal tax on inheritance?
There's no federal inheritance tax so your inheritance amount doesn't have to be reported to the IRS.
However, any gains from the estate between the time the person died and the amount is distributed to you, will have to be reported and taxedon your personal tax return, saidBrian Schultz, partner at certified public accounting firm Plante Moran.
Gains could include dividends from any stocks or bonds you may have inherited, for example.
Who pays inheritance tax?
Typically, spouses and charitable organizations are automatically exempt from inheritance taxes. Children and other dependents or grandchildren might also qualify for an exemption, partial exemption, or pay the lowest rates.
The highest rates are usually levied on those who don’t have a familial relationship with the deceased person.
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how much money can you inherit before you have to pay taxes on it?
After the executor of the estate has divided up the assets and distributed them to beneficiaries, the amount of tax is calculated separately for each individual beneficiary. Each individualmust pay that tax amount and reportthe information on an inheritance tax form to the state.
There’s usually an exemption amount for inheritance taxes that’s normally set very high, of at least $1 million, and only the amount exceeding that threshold is taxed. As a result, only about 2% of taxpayers will ever have to pay inheritance tax, according to Turbo Tax.
The inheritance tax differs fromthe federal estate tax, which levies a tax on thetotal value of a deceased person's assets, less an exclusion amount, and is typically paid out of thedeceased person’s assets before distribution to beneficiaries. Taxes are paid by the estate, instead of the beneficiary.
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Can I avoid an inheritance tax?
The best way to avoid the inheritance tax isto manage assets before death.To eliminate or limit the amount of inheritance tax beneficiaries might have to pay, consider:
- Giving away some of your assets to potential beneficiaries before death. Each year, you can gift a certain amount to each person tax-free. In 2022, that annual gift exclusion was $16,000 and moves up to $17,000 for 2023.
- Moving to a state without an inheritance tax.
- Setting up an irrevocable trust. You give up some control over theassets because the trustbecomes the official owner, and you can’t change or cancel it. But no trust assets transfer upon death, so no estate or inheritance taxes are charged.
"The bottom line is, in order to minimize the burden to your beneficiaries, it’s important to plan ahead, consider gifts throughout your lifetime, and structure documents so that assets pass to your loved ones in the most tax efficient ways," White said.
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Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at [email protected] subscribe to our freeDaily Money newsletterfor personal finance tips and business news every Monday through Friday morning.
