Most inheritances aren’t taxable, but there are several situations you need to be aware of that could require you to file a tax return or pay taxes.
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This post is provided for general information only. Please confirm the details and circumstances of your unique situation with your tax accountant or other appropriate advisor before taking action.
Is there an IRS inheritance tax?
There is no federal inheritance tax. An inheritance tax is when the person who receives an inheritance has to pay income tax on it.
Inheritance taxes are not the same as estate taxes. Estate taxes are when the estate of the person who died pays taxes before paying out inheritances to the heirs.
Do states have inheritance taxes or estate taxes?
Different states have different rules. Some have no state tax or inheritance tax, some have one or the other, and some have both.
When a state has an estate tax, it usually applies when the person who died was a resident of that state. If you live in a state with an estate tax but the relative you’re inheriting from lived in a state with no estate tax, there will typically be no estate tax.
Real estate and businesses are common exceptions. The state where the property or business was located may charge estate tax even if the owner lived in another state. The owner’s state may still charge estate taxes on those assets but will usually give a credit for the other state’s taxes.
Inheritance taxes can sometimes be a little trickier. It could go by either where you live or the deceased person lived.
For example, Kentucky charges inheritance tax to heirs of a Kentucky estate even if the heirs don’t live in Kentucky. Kentucky generally doesn’t charge Kentucky residents inheritance tax on what they inherit from non-Kentucky residents.
Other states tax their own residents for any inheritance they receive inside or outside of the state.
If you’re subject to two inheritance taxes, you usually get a tax credit so you don’t have to pay double taxes.
Like with estate taxes, the inheritance tax rules may vary for real estate or businesses located in a different state than where the decedent lived.
How do federal estate taxes work?
The federal estate tax only applies to very large estates worth millions of dollars. The current limit is around $12 million and adjusts each year.
The federal estate tax is paid by the estate, not the heirs. The decedent’s estate generally has to pay the estate tax before distributing any money to the heirs.
If the estate tax reduces what you were set to inherit according to the person’s will, your inheritance is reduced.
If the estate distributes estate assets without taking care of required taxes, both the executor and heirs may be responsible for the taxes plus penalties.
Capital Gains Tax
When you inherit non-cash assets, such as real estate or stocks, you generally gain additional tax benefits. The most important is usually in regard to capital gains taxes.
When you sell an asset you inherited, it’s generally the same as if you bought it for its fair market value on the decedent’s date of death. (There are certain situations where you can use an alternate valuation date).
For example, if someone bought a house for $100,000, you inherited the house when it was worth $300,000, and you sold the house when it was worth $500,000, you’d generally only pay capital gains tax on a $200,000 gain.
There are special rules when you inherit a retirement account from someone other than your spouse. If you inherited the account from your spouse, you can either treat it as your own or follow the special rules.
For a retirement account from a non-spouse or if you elect not to be treated as a surviving spouse, you generally don’t pay federal income taxes at the time of your inheritance. However, you typically have up to 10 years to withdraw all of the money in the account.
The withdrawals are generally subject to income tax in the same way that normal retirement account withdrawals are. If the deceased person made nondeductible contributions, you normally receive the basis for those contributions and don’t have to count withdrawing the contributions as taxable income.
Life insurance proceeds are usually not subject to income tax or inheritance tax. If you don’t take a lump sum payment or delay taking a payment, you may have to pay tax on the interest you receive.
Contracts to Pay Money
If you receive a right to receive money, such as an annuity or delayed compensation, you may need to pay taxes. For an annuity, you normally pay taxes on any payments you received that the deceased person would have had to pay taxes on and that the deceased person’s estate didn’t pay estate tax on.
For delayed compensation, such as future payments from an employer, you’d normally have to pay income tax on any payments not already covered by estate tax.
Does the IRS know when you inherit money?
The Internal Revenue Service may or may not know when you inherit money. For things like retirement accounts, they’ll usually receive tax forms from the broker. For cash inheritances, the IRS may not see a paper trail unless the estate has to file a tax return.
The IRS will usually know when someone has died and may have an estate subject to estate tax. The estate will need to file a final tax return, and the IRS might receive notifications from investment brokers or other financial institutions.
The IRS will also usually have a general idea of the potential size of a person’s estate based on his or her previous tax returns.
Does a state know when you inherit money?
States often track estates the same way that the IRS does. When a state has an inheritance tax, it often won’t allow the probate court to allow assets to be transferred to the heirs until the heirs either file an inheritance tax return or pay any inheritance tax owed.