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If you’ve just found out that someone has bequeathed you a home or another type
of inheritance, it’s time to also learn what it can mean for your responsibility
as a taxpayer.
If you've recently lost a loved one or are helping someone who has, we recognize
this can be a challenging time. Understanding the process and getting organized
are important first steps.
Contents
* What’s the Inheritance Tax?
* Which States have the Inheritance Tax?
* How Much is the Inheritance Tax?
* Inheritance Tax Filing Tips
* Tip 1: Get Your Paperwork Together
* Tip 2: Figure Out the Best Way to File
* Tip 3: Understand Other Credits and Deductions
* Tip 4: Prepare Your Estate the Right Way
* Beware of “Tax-Free” Inheritance
WHAT’S THE INHERITANCE TAX?
Inheritance tax is a tax that beneficiaries need to pay on assets bequeathed to
them upon the death of the owner of those assets. The decedent could be a
spouse, parent, sibling, friend, relative, a loved one or even an unknown person
or entity. In most cases, if you receive an inheritance, you’ll likely be
subject to an inheritance tax. However, there are exceptions to the rule.
The tax implications of inheritance are different from a windfall you might
receive — for instance, taxes are different on a sizable bonus or a Powerball
win. For tax purposes, the government considers those as ordinary income, and
you may owe federal, state and local income tax on your earnings. Inheritance is
not income, and therefore not subject to income tax.
The inheritance tax is also different from the estate tax because payment of the
latter comes from the deceased’s estate before any disbursements are made to
beneficiaries of the estate. Inheritance taxes, on the other hand, are due upon
receipt of the inheritance by individual beneficiaries and calculated on the
value of the assets bequeathed to each beneficiary.
WHICH STATES HAVE THE INHERITANCE TAX?
Eleven states had an inheritance tax in 2001. Since then, five of those states
(Connecticut, Indiana, Louisiana, New Hampshire and Tennessee) have repealed
their inheritance tax statues. Only six states impose an inheritance tax, and
one — Maryland — levies both estate as well as inheritance tax.
Estate and Inheritance Taxes Map
Among the six states that do have an inheritance tax, the applicable tax rates
differ. There are also inter-state differences with respect to exemptions
granted to lineal heirs and collateral heirs. Even where states might have
similarities in how they exempt specific classes of beneficiaries (for instance,
siblings) each state may apply different standards to whether such exemptions
should also extend to the spouses of those heirs.
HOW MUCH IS THE INHERITANCE TAX?
The rate of inheritance tax differs from state to state and may vary based on
the amount of the inheritance, decedent’s resident status (resident or
nonresident) and the beneficiary’s class (spouse, sibling, religious
institution, qualified charity, etc.).
Typically, lineal heirs (children, grandchildren and parents) are either exempt
from the tax or have a lower tax rate than collateral heirs (cousins, aunts,
uncles, nephews, nieces and unrelated individuals).
State Inheritance Taxes for 2018 Deaths
Here are a few quick facts:
* Each state has different tax classes applicable to various types of
beneficiaries.
* States also differ in how they treat the same type of beneficiary. For
instance, one state might exempt or have a lower rate for a sibling compared
to another.
* Surviving spouses are exempt from paying inheritance tax in all six states.
* Some states may offer unlimited exemptions to some beneficiaries, and only
limited exemptions for others.
* The top tax rate for lineal heirs ranges between 1% and 4.5%.
* The top rate for collateral heirs ranges from 10% to 18%.
These differences have an impact on how the amount of inheritance tax paid by a
beneficiary. For instance, the state of New Jersey exempts the first $25,000 of
an inheritance by the sibling (Class C) of a decedent, while Iowa offers no such
exemptions for sibling (Class B) inheritance. An Iowa resident inheriting up to
$25,000 from a sibling will pay tax amounting to $625 + 6% of amounts exceeding
$12,500.
While it is the responsibility of the beneficiary to ensure that you pay your
share of the inheritance tax owed, sometimes the estate of the deceased picks up
the tab. Because the inheritance tax can sometimes be substantial, some
individuals and families make provisions for dealing with the tax in their wills
so they don’t burden their beneficiaries.
INHERITANCE TAX FILING TIPS
The federal government does not have an inheritance tax, but each of the six
states that do impose it have different state inheritance laws that govern how
the tax is determined, calculated and paid. If you have received an inheritance
or are responsible for filing taxes on behalf of a deceased benefactor, here are
some tips that may help you:
TIP 1: GET YOUR PAPERWORK TOGETHER
Before you file your taxes following an inheritance, make sure you have all the
paperwork related to any of the following income that the final returns of your
benefactor did not cover:
* Employee compensation
* Benefit plan distributions
* Bonuses
* Partnership income
* Gain on disposal of inherited assets (including stocks and property)
* Royalties
* Interest and dividends on stocks and bonds
Although the actual assets might not be taxable unless they exceed the exemption
limits specified by your state inheritance tax laws, you need this documentation
so you can properly report all income received on inherited assets subsequent to
receiving the inheritance.
If you have received an inheritance, some of the best tax software tools have
features that can help you guide when you file your taxes.
TIP 2: FIGURE OUT THE BEST WAY TO FILE
Generally, it’s the responsibility of the executor of your benefactor’s will who
must file taxes on behalf of the deceased. However, where no such person exists
(for example, there may be no executor appointed to oversee the distribution of
the inheritance), the beneficiaries are responsible for filing those tax
returns. You may even file as a surviving spouse or qualifying widow/widower.
Consult IRS Form 1041 for additional filing guidelines.
When filing your inheritance tax forms, there may be an opportunity for you to
reduce the amount of tax you pay on inherited property that you disposed of. It
all hinges on what you elect as the “basis” of the properties’ value. You could
choose the fair market value (FMV) on the date of death of the decedent or
choose an alternate method (elected in Form 706) that values the property six
months post the date of death. Carefully weighing which “basis” to use could
reduce your taxes significantly.
If you withdraw from your own as well as an inherited IRA, each of which has a
separate “basis,” then you need to prepare two Form 8606s when filing your
taxes. This will help you determine what portion of those distributions are
taxable and which aren’t. As a beneficiary, you could potentially claim an
estate tax deduction on distributions that you may have received from an
inherited traditional IRA.
Another element you might need to be aware of is when dealing with Income In
Respect of a Decedent (IRD). IRD refers to untaxed income which a decedent
earned or had a right to receive during his/her lifetime. IRD is taxed to the
beneficiary that inherits this income.
If you’ve never prepared your own taxes before, it might be a good idea to learn
what’s involved in filing taxes before you proceed.
TIP 3: UNDERSTAND OTHER CREDITS AND DEDUCTIONS
Most states exclude inheritances of up to a certain amount from the inheritance
tax. Before filing your taxes, make sure you are aware of the exemption limits
applicable for your state.
If you inherit assets from an IRA account, you don’t pay any taxes until you
withdraw the money. Since those withdrawals are “other” income for your tax
determination, you can offset that income against other eligible credits and
deductions.
If you sell an inherited property for gain, that appreciation is taxable as
capital gains. However, you can deduct selling expenses, such as realtor’s
commissions and listing fees, from your gains.
TIP 4: PREPARE YOUR ESTATE THE RIGHT WAY
If you plan to leave an inheritance to someone, a great tax-effective way to
deal with such transfers is through a trust structure. Putting assets from your
estate into trust allows them to pass on to beneficiaries without
probate-related taxes and expenditures.
If you hold assets such as a cottage or family home in joint ownership with a
child or sibling, the death of one owner can trigger a massive capital gains tax
for the beneficiary, especially if the owners held it over a long period of
time. Revocable trusts might be a better vehicle to house such assets.
If you have a sizable estate that you intend your beneficiaries to inherit upon
your passing, it might be more tax-efficient to give away some of the intended
inheritance while you are still living. There is a fixed amount that you can
gift to your future beneficiaries — the threshold is $15,000 per individual each
year.
By giving away some of your estate during your lifetime, you not only get to see
your loved ones enjoy part of your estate, it also reduces the overall value of
your estate, which can subsequently reduce estate and inheritance taxes upon
your passing.
BEWARE OF “TAX-FREE” INHERITANCE
One final word of caution for beneficiaries who live in states without an
inheritance tax, or who are exempt from paying the tax under their states’
inheritance tax laws: Your inheritance might still come with a tax tab attached!
While the inheritance comes to you with no strings attached, any income or
earnings such as dividends, interest, rental income etc. from such tax-free
inheritance is taxable, both at state and federal levels. Additionally, if you
decide to dispose of the inheritance (shares in a publicly-traded company or
real estate), the proceeds received might also be subject to capital gains
taxes.
If your state imposes an inheritance tax, it might be advisable to learn how to
file state taxes before filing your tax returns this year.
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