How to Do Your Taxes After You Get an Inheritance

December 23, 2020

Have you ever thought about the possibility of receiving an inheritance? You should. Some experts estimate that over the next 30 years about $36 trillion will flow from one generation to the next. Given the magnitude of this amount, there’s a good chance that you might become a beneficiary one day. And when that happens, it pays to know how to handle this potential new tax burden.

If you’ve recently received an inheritance or expect to receive one in the next few years, it’s important to know how inheritance taxes work. In this post, we’ll explore the different types of taxes that are required for inheritances, who has to pay them, and how you can reduce the amount that the IRS expects to receive.

What is Inheritance Tax? 

An inheritance tax is a state-imposed tax upon the beneficiaries who have received assets or property from someone who has passed away. It is one of two commonly so-called “death taxes”: namely, inheritance tax and estate taxes.

Currently, only six U.S. states impose an inheritance tax:

  • Iowa
  • Kentucky
  • Maryland
  • Nebraska
  • New Jersey
  • Pennsylvania

If you do owe inheritance taxes, the amount will be dependent on several different factors such as:

  • Your state of residence
  • The value of the inheritance
  • Your relationship to the deceased

How to Do Your Taxes After You Get an Inheritance

Taxes at the Federal Level

The federal government doesn’t consider money received by beneficiaries to be income. Therefore, there is no federal inheritance tax. 

For instance, if grandma passes away and leaves $10,000 to her granddaughter, that’s not considered to be the same thing as having earned $10,000 from a regular job. It’s assumed that this money was likely already taxed back when the benefactor had earned it. So for that reason, no one will have to pay any tax on this inheritance.

State Inheritance Taxes

State inheritance tax will only apply if the benefactor who left you the inheritance lived in any of the six states mentioned above. If their residence was in one of the other 44 states where they do not collect inheritance tax, then you shouldn’t owe any inheritance tax. This is true even if you live in one of these six states where inheritance tax is collected.

State and Federal Income Taxes

Since inheritance benefits aren’t considered income, you generally don’t have to report what you’ve received on your state and federal income taxes. However, this will depend on the type of asset you’ve received. In some cases, there may be some special rules that you’ll have to abide by. 

For instance, if you inherit a non-spousal IRA, you’ll have to start distributions and empty the account within 10 years of the death of the original account holder. Each distribution will be taxed at the beneficiary’s current income tax rate.

Capital Gains Tax and Inheritance

If the benefits you’ll be receiving are things like stocks, funds, or even property, these are all assets that have the potential to increase in value over time. That makes your tax situation a little more complex.

Anytime you own something (aka “capital”) and you’re able to sell it for more than its value, you’ll make what’s called a “gain”. Hence, this is called a capital gain and the IRS expects to collect their share of these profits.

Fortunately, capital gains are taxed at a different and lower marginal tax bracket system than regular income taxes. That means the amount of money you owe from an inheritance that qualifies as capital should be less.

In addition to this, assets that are inherited receive a special “stepped-up basis” exemption. Normally when you calculate a capital gain, you take the price you sold it for minus the price you originally paid for the asset. But with a stepped-up basis, you get to bump up the value from what the benefactor paid for it to whatever it was at the time of their death.

For example, let’s say you inherited a portfolio of stocks from your father last year and you now wish to sell them for $100,000. If your father had originally purchased those stocks for $20,000, under the normal rules for capital gains, taxes would be owed on the $80,000 gain.

However, thanks to stepped-up basis, those stocks may have been worth $90,000 at the time that your father passed away. Under this condition, you’d now only be liable for the taxes on a $10,000 gain.

State and Federal Estate Taxes

At the federal level, there may be taxes owed on the value of the estate. However, for the majority of people, this would only apply if the value of the estate was quite substantial. As of 2021, the minimum value before estate tax kicks in is $11.7 million for individuals and $23.4 million for married couples. That means you are exempt from paying any federal taxes on inheritances under $11.7 million ($23.4 million for married couples). After that exemption is reached, in the case of a very large inheritance, you will have to pay estate taxes on the remainder at the current rate of 40% (2020). 

At the state level, so-called “death taxes” will depend on where you live. Currently, there are 12 states (Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington) plus the District of Columbia where estate taxes are collected. 

Similar to the federal estate tax, this will depend on how much the estate is valued. However, bear in mind that the minimum requirements will be much less (starting around $1 million).

Though the beneficiaries do not have to pay for these taxes out of pocket, the estate does have to settle them before they can begin distributing its assets. As you might guess, these estate taxes will reduce the amount of estate assets leftover for the beneficiaries.

Do You Have to Report Inheritance Money to the IRS?

Generally speaking, no. Because the IRS doesn’t consider an inheritance to be taxable income, there’s no reason to report it to the IRS. 

The only time this would apply is if the type of asset triggers any of the other taxes we’ve already mentioned above. For example, if your assets were stocks or a 401k account, then you might have to pay capital gains or be required to take distributions (which are taxable and should be reported).

Does the IRS Know When You Inherit Money?

Yes and no.

The IRS will not know right away when funds or property have been transferred. However, they do have the means to find this information out eventually.

For starters, if the estate is being handled through a will and taxes are due, then the IRS would have access to how much the total estate was worth and who the beneficiaries were. They could then cross-reference this information against your own tax returns or financial statements to see if everything aligns.

Similarly, bank deposits over $10,000 are required to be forwarded over to the IRS. So, if you receive a large payout and don’t make any declarations on your filings, this could also trigger a red flag.

Remember that failure to properly disclose taxable information to the IRS can result in some stiff penalties and fees. In more extreme cases, it could even result in going to court or possible criminal charges. The best thing to do is to hire a professional to manage these taxes for you and be as transparent as possible.

What’s the Difference Between Inheritance Tax and Estate Tax?

A lot of people use inheritance tax and estate tax interchangeably. But they aren’t the same thing. Estate and inheritance taxes are different in the following ways:

  • Inheritance taxes focus on the beneficiary (the living person receiving the estate)
  • Estate taxes focus on the benefactor (the deceased person giving away their estate)

For example, let’s pick a state like Maryland that has both inheritance and estate taxes. Let’s also say your wealthy grandfather (resident of Maryland) has passed away and left you his entire $15 million estate. This would trigger both types of taxes:

  • The amount over the $11.7 million exemption in Grandfather’s estate — in this case $3.3 million — would be taxed at both the federal and state level because it exceeds the minimum estate tax threshold
  • You would also owe inheritance tax since your grandfather was a resident of Maryland 

Alternatively, if grandfather had lived in Michigan, then only estate taxes at the federal level would have applied. His estate would not owe any state estate taxes and you wouldn’t have to pay any inheritance tax.

How to Avoid Inheritance Tax

Whether you’re doing estate planning for your own affairs or helping a family member, there are several steps you can take to reduce or avoid the inheritance tax altogether.

Move to a State That Doesn’t Have Inheritance Tax

The obvious way to avoid burdening your future beneficiaries with inheritance tax is to move to a state that does collect it. Many states also exempt the spouse and children of the deceased from paying inheritance taxes, but again this varies from state to state. 

Open a Trust

Trusts can do more for you than just avoid probate. Depending on the type of trust you open, it may also help lower your tax burden once the benefits are distributed.

Put the Money into Whole Life Insurance

Generally, the benefits paid out to the beneficiary of a life insurance policy are not considered taxable income. Therefore, a benefactor could purchase a whole life policy and offset the amount of money their beneficiaries would receive via the estate. 

Give Away Some of the Money

Though it may seem counter-intuitive, one way to relieve your beneficiaries of inheritance tax would be to donate a portion of your wealth before you pass away. The current federal limit on tax free gifts is $15,000. That means you can give up to $15,000 to as many people as you like — tax-free — while you’re living or even after your death. Your spouse can also gift an additional $15,000 doubling up tax-free “living” inheritances like this each year.

Work with a Tax Professional

If all of these rules with taxes seem confusing, it’s because they are. Taxes are complicated, and that’s why it’s best to work with a reputable tax professional who knows the laws and can help you navigate them efficiently.

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