Understanding Inheritance Tax: Obligations and Potential Avoidance Strategies

After losing a loved one, taking care of their wishes is a top priority. In some cases, the deceased may have left assets behind for you to inherit. The generous gesture is often a touching reminder of their love for you.

As you move forward with this inheritance process, it’s important to consider how inheritance tax may play a role in your life. Depending on state laws, you may owe an inheritance tax on any property or money that you inherit.

Let’s take a closer look at how this could impact you.

What Is Inheritance Tax?

An inheritance tax, in certain states, requires a beneficiary to pay a tax on inherited money or real estate.

Inheritance tax rates vary by state, and the amount of tax paid depends upon multiple factors. Inheritance tax is different from income tax.

Exemption from inheritance tax depends on the relationship of the beneficiary (the person who receives the asset) to the decedent (the deceased person).

Estate Vs. Inheritance Tax: What’s The Difference?

While the terms inheritance tax and estate tax are sometimes used interchangeably, they are two separate things. Estate tax is the dollar amount taken out of someone's estate after their death.

An inheritance tax is what the beneficiary has to pay when they receive an asset from the decedent. In some cases, an estate and inheritance tax could both be enacted within the same situation.

However, it’s important to distinguish between the two. An estate tax is sometimes referred to as the “death tax” because it’s a tax taken out of someone’s estate after their death.

In addition, an estate tax is a federal tax, while an inheritance tax is a state tax. A few states also have estate taxes, but it’s important to distinguish that an inheritance tax is not a federal tax.

How Much Is Inheritance Tax?

As of 2021, the federal estate tax only applies to estates that total more than $11.7 million. Those estates will be taxed at anywhere from 18 – 40%, depending on the dollar amount over the threshold. States with an inheritance or estate tax typically have varied rates for their taxpayers, but the maximum amount any state can charge is 20%. 

As a reminder, inheritance taxes are different from state and federal estate taxes. Inheritance tax rates vary based on the three factors.

First, the deceased person’s residence can affect the inheritance tax rate. This means that the state issuing the tax will greatly impact the amount you’ll pay with their unique tax rate.

Second, the total value of the inheritance will have an obvious impact on the inheritance taxes paid.

Finally, your relationship to the deceased will play a role. A more direct relationship to the deceased will often lead to a lower tax rate.

Beyond inheritance taxes, you’ll need to consider the other potentially related taxes. A couple to look out for include capital gains tax and income taxes.

If you decide to sell an asset that you inherited, then capital gains taxes could come into play. The recipient will be responsible for paying the inheritance tax on received assets and the capital gains tax on the amount of profits earned from the date of death, not when the assets were originally purchased.

Inheritance Tax By State

As with many tax regulations, inheritance tax rates vary by state. Within each state’s tax rates for inheritance taxes, you’ll find different rules based on your relationship with the deceased.

Currently, six states impose an inheritance tax: Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania and Iowa.

Here’s a closer look at the tax rates that you could expect to pay in each state:

States	Tax Rates
Iowa	0 – 15%
Kentucky	0 – 16%
Pennsylvania	0 – 15%
Maryland	0 – 10%
Nebraska	1 – 18%
New Jersey	0 – 16%

Because each state has slightly different rules surrounding their inheritance taxes, it is important to seek out guidance from an expert in your home state.

Do You Have To Pay Taxes On Inheritance?

Even though inheritance is not considered income, it is still taxable in several states. Any earnings from inherited assets are also eligible for taxation, if not from a tax-free source. 

However, nonresidents of the previously listed states are not required to pay this tax. In most circumstances, immediate family members and surviving spouses are also exempt from inheritance taxes. Distant relatives and friends will have fewer exemptions in their favor.

As mentioned earlier, it is likely that a beneficiary might have to pay other taxes on inherited assets, like a 401(k) or IRA.

The Bottom Line

To review, an inheritance tax requires a beneficiary to pay a tax on inherited money or real estate. An inheritance tax is different from an estate tax, as it is not a federal tax. Inheritance tax rates vary by state and may need to be paid by beneficiaries who live in Maryland, Nebraska, Kentucky, New Jersey, Pennsylvania and Iowa.

As you navigate the tax laws surrounding inheritance, don’t be afraid to ask for help. Learn more about estate planning to better understand the laws that surround inheritances and wills.