Inheritance tax is a complex tax law that may affect the inheritance you leave your beneficiaries. This tax mainly depends on the state the deceased lived in, the person receiving the property, and the amount.
However, many exemptions, exceptions, and varying tax rates can make inheritance tax a complicated subject. Learn more about inheritance tax to see if you may be subject to paying it and ways to legally avoid the tax to ensure your beneficiaries receive all of the money you want them to.
What is Inheritance Tax?
Inheritance tax is a levy on an inheritance from someone who has died. An inheritance tax is paid for by the person receiving the inheritance. The inheritance can be in the form of money, property, or other assets such as stocks and bonds. It is not the same as estate tax, which is assessed on and paid for by the estate itself before being distributed.
The U.S. Federal government does not have an inheritance tax. It will not tax the inheritance as income unless the inherited assets produce an income, such as rental properties or stocks.
As of 2022, only Pennsylvania, New Jersey, Nebraska, Maryland, Kentucky, and Iowa collect taxes on inheritance. Those receiving an inheritance from a resident of a state not mentioned will not need to pay taxes on the inheritance they receive.
However, it’s important to remember that inheritance and estate taxes are different, and a state and/or federal estate tax may be placed on the estate you inherit from. While this will not make a difference on your tax return or tax liability, it’s essential to understand that the amount you believe you are owed may be slightly different than what you receive because of this tax.
Inheritance Tax Exemptions and Rates
Anyone who receives an inheritance from someone who lived in or owned property in Pennsylvania, New Jersey, Nebraska, Maryland, Kentucky, or Iowa will be subject to inheritance taxes. However, multiple exemptions apply based on the relationship between the deceased person and the heir, the value of the estate, and the amount received.
Most of the six states that impose an inheritance tax have exemptions depending on the relationship between the deceased and the heir.
- Pennsylvania: Spouses and minor children of the deceased are exempt from inheritance tax.
- New Jersey: The spouse, children, parents, grandparents, and grandchildren are exempt from tax. Siblings and sons or daughters-in-law are exempt up to $25,000.
- Nebraska: Spouses are fully exempt from tax. Parents, grandparents, siblings, children, and grandchildren are exempt up to $40,000. Other relatives are exempt up to $15,000, and unrelated beneficiaries are exempt up to $10,000.
- Maryland: Parents, grandparents, spouses, children, grandchildren, and siblings are exempt from inheritance tax.
- Kentucky: Spouses, children, parents, and siblings are exempt from taxes. Other recipients are exempt up to $500 or $1,000.
- Iowa: Spouses, children, and parents are exempt from tax.
Value of the Estate
In most states, the inheritance tax rate is only measured by the amount received by the heir. However, the estate’s total value is also considered in Maryland and Iowa.
- Maryland: Inheritances from estates with less than a $50,000 value are exempt from paying inheritance taxes.
- Iowa: Inheritances from estates smaller than $25,000 is exempt from taxes.
Tax rates vary widely between states and even within the state, depending on the amount a beneficiary received or the relationship to the deceased.
- Pennsylvania: For those not exempt, the tax rate is typically 4.5%, 12%, or 15%, depending on the relationship to the deceased. Payments under $25,000 have 0% tax.
- New Jersey: The tax rate is 11-16% depending on the size of the inheritance and the relationship to the deceased.
- Nebraska: Tax rates are between 1-18% above the exemption thresholds.
- Maryland: Recipients beyond the family exemptions have a tax rate of 10%.
- Kentucky: The tax is on a sliding scale between 4% and 16% (after the first $1,000) based on the size of the inheritance.
- Iowa: The tax rate on others is between 5% and 15%.
In most states, there are additional exemptions based on the deceased individual or on where they will donate their money.
- Pennsylvania: Property transferred by someone who died while serving in the armed forces is exempt from tax. Property left to charitable organizations and government entities is also exempt from tax.
- New Jersey: Non-profit organizations and charities are exempt.
- Maryland: Maryland nonprofits are exempt from taxes.
How to Reduce or Avoid Inheritance Tax
To ensure you receive all of the money you’re entitled to, there may be ways that you can legally reduce or avoid inheritance taxes. Many of these options must be in place before passing away, so getting started as soon as possible is essential.
Make Use of Exemptions and Allowances
Most exemptions are for immediate family members, which is not something that can be legally changed apart from the spouse. If you can, marrying your partner may be the best way to ensure they receive a tax-free inheritance in the event of your death.
This option shouldn’t be taken lightly, but if you know the majority of your estate will go to your partner, it may be worth getting married for tax purposes, as even civil partnerships are subject to taxes in all states that tax inheritance.
If you choose not to marry or leave property to someone who will be subject to taxes in your state, it might be a better idea to choose a life insurance policy. You can take the amount of money you wish to leave the person, put it into a life insurance policy, and name that person as the beneficiary on the policy.
Death benefits from insurance policies are not subject to inheritance taxes in any state.
Another way to reduce inheritance tax is to use trusts. A trust is an arrangement in which property or assets are held by one person (the trustee) for the benefit of another person (the beneficiary). This removes your property from your estate and eliminates its classification as an inheritance upon death. Therefore, there will be no inheritance tax on them.
But trusts can be a complicated process that must comply with state tax laws and should be worded carefully. Therefore a trust and estates attorney should be involved in this process.
Give Gifts During Your Lifetime
Another way to reduce inheritance tax is to give gifts during your lifetime. You can give up to $16,000 worth of gifts each year without any gift tax liability. This ensures you are leaving your family the money you wish without the need to pay a federal or state tax on them.
Move to a State Without an Inheritance Tax
While this may seem like a drastic decision, moving to another state may be worth it if you have a substantial estate and are planning to leave large amounts to people who will be subject to high tax rates. Because inheritance tax is based on where the deceased person lived, not the beneficiary, the inheritance will still be taxed even if your beneficiaries live in a tax-free state.
Just ensure you understand the tax laws of the new state and have taken into account estate taxes, as your new state may impose a higher estate tax than your current one, making the move futile.
Instances Inheritances Are Taxed
If you inherit a rental property that generates income, you must pay income taxes. Other inheritances, such as stocks, bonds, and dividend payments, will also be subject to tax.
You may also be subject to capital gains tax if you sell an inherited property for a profit. The capital gains tax is only subject to the increase in value after you inherit the property. For example, if you inherited the property at a value of $200,000 and sold it for $250,000, you will only be taxed on the $50,000, no matter what the deceased person paid for it originally.
Learn More About Inheritance Taxes with Finance is us
Inheritance tax is a complex issue that varies widely by state. The person leaving property, those receiving it, and the amount also play a role in possible taxes, making it difficult to understand. To better understand inheritance taxes, as well as other taxes such as estate taxes, income tax, and capital gains tax, be sure to follow Finance is us.
Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.