An inheritance tax is a state tax that you will pay on an asset (such as property or money) you get from somebody who has passed away. Once upon a time, all 50 states had this tax, but with time, more states have done away with it. Nowadays, a handful of states still have the tax: Iowa, Pennsylvania, Kentucky, Nebraska, Maryland, New Jersey.
Is an Inheritance Taxable?
The short answer: yes. Your inheritance can be taxed in 2 ways: inheritance tax and estate tax. However, you are responsible to pay inheritance tax. Estate tax comes directly out of an estate before it is distributed and divided. Whether you will have to pay an inheritance tax depends on which state the deceased lived in, as there’s no federal inheritance tax. Only 6 states still impose an inheritance tax: Iowa, Kentucky, Pennsylvania, Maryland, Nebraska, New Jersey. Even if you live in one of those 6 states but the deceased didn’t, you will not have to pay inheritance tax.
State laws are subject to change though, so double-check with your state tax agency. A 3rd way you end up paying for your inheritance is via state and federal income taxes. Inheritance is not considered income, but specific kinds of assets you inherit might have tax implications. You might have to pay taxes when you take the distributions from an inherited retirement account or when you sell inherited real estate or stocks. In fact, getting an inheritance from somebody who has passed away isn’t a taxable event, but how much tax you’ll pay when you take money out of that asset for instance by selling a stock or distributing money from a retirement account depends on the asset itself. Here is why.
You have a step-up basis, then You’ll owe less tax if you will sell
When an heir gets an asset from a decedent, the value of the property must be determined. Commonly, this new, adjusted value (called the adjusted basis) for income tax purposes is the current fair market value (FMV) of property as reported on the estate tax return of the decedent. This can be either the FMV at the decedent’s date of death or the alternate valuation date (6 months after the death’s date) if that was selected. This new basis is referred to as a step-up basis for the heir because the heir steps up from the old, low basis to the new, high basis. The basis is significant because it determines how much tax you will have to pay when you sell.
The holding period for the property you inherit is deemed to be a long-term investment (that is subject to low long-term capital gains rates). This applies irrespective of how long you hold the property before selling it. If you gifted an asset to the decedent within 1 year of the death of the decedent. If you inherit the asset from the person that you had gifted to the decedent in 1 year of his or her death, then you will not get a step-up in basis. Your basis will be the basis of the decedent, which will be similar to your original basis before you made the gift.
When you get life insurance proceeds. If you are the beneficiary of a life insurance policy on someone who has passed away, as a general rule, the death benefit paid to you won’t be subject to income tax. The exception is if the decedent owned the policy first and then gave you the policy (that is made you the policy’s owner) in exchange for valuable consideration (that is you gave the decedent something in exchange for receiving the policy or there was an economic reason behind transferring the policy). This’s known as the transfer for value rule.
How Do Inheritance Taxes Work?
Now for some good news. Uncle Sam doesn’t have an inheritance tax and inheritances aren’t considered taxable income in most cases so you will not have to report your inheritance on your state or federal income tax return. For instance, if your father-in-law from a no-inheritance-tax state leaves you $25,000, and you live in, say, New Jersey – a state with an inheritance tax exemption threshold of $25,000 for siblings as well as children-in-law that will not be considered income and you will enjoy the inheritance while not worrying about taxes.
Let us say, your father-in-law was in New Jersey and left $50,000 for you. You will pay an inheritance tax of 11 percent on the remaining $25,000 ($50,000 to $25,000) when it passes to you. Every state is different and taxes can change at the drop of a hat, so it is a better idea to check your state’s tax laws, or good yet, talk to a tax pro.