Who hasn't dreamed of inheriting a huge windfall from a long-lost relative? While dreaming of how you'd spend the money can be fun, in reality, receiving an inheritance can occasionally come with a not-so-welcome surprise: a tax bill.
Here's what you need to know about inheritance taxes and how to minimize them.
What is an Inheritance Tax?
The inheritance tax is one of two kinds of "death taxes," both of which can kick in when someone dies.
- Estate tax. An estate tax is charged to the estate, regardless of who inherits what. When someone dies with a considerable amount of assets, their executor may need to file an estate tax return and pay estate taxes before distributing any remaining assets to heirs.
- Inheritance tax. An inheritance tax applies to the person who inherits money. The executor distributes money to the heirs, and each recipient handles calculating and paying their own inheritance taxes.
The federal government only levies an estate tax, not an inheritance tax. And it affects less than 0.1 percent of Americans.
That's because, for 2021, the IRS exempts estates worth less than $11.7 million per person. A married couple can die with an estate worth up to $23,400,000 and pay no federal estate taxes. However, anything over the exemption is taxed up to 40 percent.
Before you start counting the millions that Great Uncle Orville is bound to leave behind, keep in mind that states may have their own estate and inheritance taxes – and the exemptions can be much lower.
Estate and Inheritance Taxes by State
Twelve states and the District of Columbia have an estate tax, and six states have an inheritance tax. Only Maryland has both.
While you should really speak to a tax professional to understand the estate and inheritance tax rules in your state, here are the jurisdictions with an estate tax, as well as the exemption amount:
- Connecticut: $5.1 million
- District of Columbia: $5.8 million
- Hawaii: $5.5 million
- Illinois: $4 million
- Oregon: $1 million
- Maine: $5.7 million
- Maryland: $5 million
- Massachusetts: $1 million
- Minnesota: $3 million
- New York: $5.9 million
- Rhode Island: $1.6 million
- Vermont: $2.8 million
- Washington: $2.2 million
Here's a broad overview of some of the rules in each state that levies an inheritance tax.
- Iowa. There's no inheritance tax on estates valued at $25,000 or less. Iowa also exempts inheritances for spouses, direct descendants, parents, grandparents, and great-grandparents. For heirs that don't qualify for an exemption, the top tax rate is 15 percent.
- Kentucky. There is no inheritance tax for spouses, parents, children, grandchildren, or siblings. Nieces, nephews, daughters- or sons-in-law, aunts, uncles, and great-grandchildren get a $1,000 exemption. Bequests over that exemption are taxed from 4 percent to 16 percent, depending on the estate's size. Other beneficiaries get a $500 exemption and pay a tax rate from 6 percent to 16 percent.
- Maryland. There is no inheritance tax for spouses, children, grandchildren, parents, siblings, grandparents, or spouses of a child or grandchild. Other individuals pay a 10 percent tax.
- Nebraska. There is no inheritance tax for spouses. Any inheritances going to parents, grandparents, siblings, children, or grandchildren have a $40,000 exemption. After that, a 1 percent tax applies. For aunts, uncles, nieces, and nephews, a $15,000 exemption and 13 percent tax rate apply. Other beneficiaries pay up to 18 percent on amounts over $10,000.
- New Jersey. Spouses, direct descendants, and direct ancestors don't pay an inheritance tax. Siblings, sons- and daughters-in-law have a $25,000 exemption. After that, a rate of 11 percent to 16 percent applies. Everyone else pays 15 percent on bequests up to $700,000 and 16 percent over $700,000.
- Pennsylvania. There's no inheritance tax for spouses. Other transfers to direct descendants are subject to a 4.5 percent tax rate. Siblings pay a 12 percent rate, and other heirs pay 15 percent. There are other exemptions for farmland and agricultural property.
If you don't live in one of these six states, inheritance taxes likely won't affect you. However, if you receive an inheritance from someone who lived or owned property in a state with an estate tax, those taxes can reduce the amount you ultimately receive.
How to Reduce or Avoid the Inheritance Tax
If you live in one of the six states with an inheritance tax, there are a few ways your loved ones can reduce the bite of inheritance taxes. Most of these strategies have to be taken by the person leaving money to you, but it's worth a frank conversation if it can reduce your tax bill.
Ensure There's a Will
When someone dies without a will, the state's laws where they live and own property determine what happens to their assets and who gives them away. While the court sorts this out, the assets go into probate, where they're frozen until the court combs through the estate's details, pays off debts, and makes decisions about how to allocate assets. This process can involve a lot of paperwork and court appearances by lawyers, and the estate pays their fees.
So talk to your loved ones about making a will. This can significantly reduce the time and expense involved in distributing their assets.
Give Assets Away Before Death
If your loved ones want to help you avoid inheritance taxes, they can consider giving their money and property away while they're still living.
Currently, individuals can give up to $15,000 per recipient per year without triggering federal gift taxes. Married couples can give $15,000 each, meaning they can give a total of $30,000 per person per year.
There are a few other gifting strategies that can help avoid gift, estate, and inheritance taxes, including:
- Contributing up to $75,000 to a 529 college savings plan in one year and treating it as if you gifted it over five years
- Covering a loved one's educational expenses by paying tuition directly to the educational institution
- Covering a loved one's medical expenses by making payments directly to the medical facility
Utilize a trust
A trust is a legal document that allows people to pass assets to their heirs without going through probate. It can also legally shield the person's estate from estate and inheritance taxes.
Setting up a trust isn't a DIY project, so you should have an estate planning attorney walk you through the details.
Find a Qualified CPA With Taxfyle
Estate and inheritance taxes can be complex, and trying to figure all of them out on your own is a recipe for disaster. Thankfully, Taxfyle can put you in touch with a qualified and experienced CPA who can offer advice and recommendations specific to your situation. Connect with one today!