Note to readers - Nothing that follows is to be taken as legal advice. Before making any decisions regarding your own tax status seek the advice of an attorney or a financial professional.
Most Americans don't understand how much they pay in taxes.
This is true of taxes in general; most Americans, for example, believe the canard that half of all workers pay nothing in taxes. Nowhere is this more true than with inheritance and estate taxes. In a 2017 survey conducted by the HuffPost, 63% of Americans believed that poor and middle class families pay most of these taxes. Another 30% believed that a majority of households have to pay the estate tax.
This is partially due to a long standing campaign on the part of anti-tax advocates who have convinced large sections of the electorate that estate and inheritance taxes will harm them and their families. For example, the American Farm Bureau Federation published the following statement on its website:
Individuals, family partnerships and family corporations own over 99 percent of our nation's over two million farms and ranches… Yet, our nation's estate tax policy can be in direct conflict with the desire to preserve and protect our nation's family-owned farms and ranches.
Farm Bureau believes that tax laws must protect, not harm the family farms that grow America's food and fiber… What is needed are tax policies that do not punish capital-intensive businesses like farms and ranches, and that do not hinder sons and daughters from following the agricultural legacy of their parents. (Emphasis original)
At time of writing, approximately eight (this is not a typo) family owned farms were large enough to trigger the estate tax when the current owner dies.
With so much misinformation out there, it's important to understand the difference between estate taxes and inheritance taxes, exactly what these taxes are, how they work and who pays them.
What Is an Inheritance Tax?
An inheritance tax is a tax the you pay when inheriting wealth. It is paid by the person who receives the estate. For example, assume that your Uncle Fred dies and leaves you a million dollars in his will. Under an inheritance tax you might pay taxes on that million.
Inheritance taxes are only levied by the states. The federal government taxes inheritances through the estate tax. The specifics of an inheritance tax will vary from state to state. Some jurisdictions allow tax-free exemptions for family members such as spouses and children. Each will also have its own tax rate and minimum threshold for taxation.
At time of writing, only six states have levied an inheritance tax: Iowa, Kentucky Maryland, Nebraska, New Jersey and Pennsylvania. For a breakdown of each state's tax rates and exemptions, see this chart published by the JRC Insurance Group. (Current as of 2019.)
Inheritance Taxes vs. Estate Taxes
When discussing taxes on inherited wealth it is essential to understand: Estate taxes and inheritance taxes are not the same thing.
This is frequently a point of confusion, because many articles will use the terms interchangeably. Given that both are taxes triggered by the inheritance of an estate, this confusion makes some sense.
What Is an Estate Tax?
An estate tax is one that a deceased person's estate pays before the heirs receive any money and/or property. For example, assume that your Uncle Fred dies and leaves you a million dollars in his will as above. Under an estate tax the government would tax this money directly from the estate and then you would inherit it.
The estate tax is how the federal government taxes inherited wealth. There is no dedicated federal inheritance tax. In addition, the following 12 states collect an estate tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington. The District of Columbia also collects an estate tax.
Because an estate tax is assessed before heirs inherit it is more likely that a large estate will qualify for taxation. For example, assume that Uncle Fred dies, however in this case he leaves $12 million. This would qualify for estate taxation in every relevant jurisdiction. Then, say he leaves six heirs $2 million apiece. Since inheritance taxes would be assessed on the $2 million, not the $12 million, this would fall below the cap for most states' inheritance taxes.
Assessing the tax before the estate is split among beneficiaries can often significantly impact the tax outcomes.
Who Pays Estate Taxes?
Contrary to public perception, typically only the very wealthy pay estate taxes. At time of writing the current cutoff for IRS taxation was $11.4 million for single taxpayers, $22.8 million for married couples. This means that any estate worth less than that is completely exempt from taxation and any qualifying estate is only taxed above the cap.
For example, say your Uncle Fred died and left you $11.5 million, that's $100,000 above the exemption. The estate would pay $23,800 in taxes on the entire amount, an effective tax rate of approximately 0.002%.
Of the states which impose an estate tax each has its own cutoffs and exemption. No state taxes estates worth less than $1 million and most require a multi-million estate before imposing taxation.
How Inheritance Taxes Work
The mechanism of an inheritance tax is virtually identical to any other form of tax. On Tax Day for the year you inherited the money, you must file your inheritance tax with the state if you qualify. Further, depending on when you received the money, you may owe estimated taxes in advance.
As a rule of thumb, if you receive the money more than three months before the end of the year you should file an estimated inheritance tax.
Inheritance Tax vs. Income Tax
Inheritances are an extremely rare carve out for the IRS. The agency does not consider inheritances income for the purposes of the federal income tax. As a result, if your inheritance was not large enough to trigger the estate tax, you won't owe the federal government a dime.
At time of writing this was also true for all states with income taxes. However, state income tax laws vary and you should always confirm when filing your taxes.
Capital Gains Taxes
Whether or not you owe money on assets that you inherit, you will always owe money on profits you make off those assets.
State governments and the IRS will tax all capital gains and profits off of inherited assets as normal. For example, say you inherited a stock portfolio. You will not pay taxes on the value of that portfolio when you receive it, however you will owe capital gains taxes on any profits that you realize when you sell the stock. Depending on your specific circumstances you may be able to assess the value of those gains at either the price paid by the person who left you those stocks or at the present value when you inherited those stocks. This is on a case-by-case basis.
The same is true of income generating property, physical property that you sell and all other profit-generating assets. If you realize capital gains off an inheritance you will have to pay the relevant taxes.
If you inherit someone's retirement account, any withdrawals you make from it will typically be taxed as ordinary withdrawals from that fund. This means that a 401(k) or an IRA will be subject to ordinary income tax, while withdrawals from a Roth IRA will not trigger any income taxes.
Even in states with an inheritance tax, spouses inherit tax-advantaged retirement accounts for free.
Inheritance vs. Jointly Owned Property
Finally, an inheritance tax does not apply to any jointly owned property. If you jointly owned something (meaning that both of you claimed equal and full rights to the title) with the deceased, you do not owe inheritance taxes. The property is simply yours.
If you jointly held shares of property (meaning each of you owned a portion of the title) with the deceased, then you will owe inheritance taxes upon receiving their share of the title.
Who Pays Inheritance Taxes and How Much?
In the six states that levy an inheritance tax, each has a slightly different scheme for taxation. The most common situations are as follows. (Note that this is not a comprehensive list. For your specific situation, seek legal counsel.)
Spouses, parents, grandparents, children and grandchildren are exempt.
Most charities are also exempt.
Siblings, sons-in-law and daughters-in-law: 5% - 10% on all inherited wealth.
All other relations; All unrelated individuals: 10% - 15% on all inherited wealth.
Corporations and other non-charity/exempt organizations: 15% on all inherited wealth.
Spouses, parents, children, grandchildren, siblings and half-siblings are exempt.
Nieces, nephews, aunts, uncles, sons-in-law, daughters-in-law and great-grandchildren: Exempt up to $1,000. Taxed at a sliding scale from 4% to 16% on all inherited wealth above that cap.
All other relations; All unrelated individuals and organizations: Exemption up to $500. Taxed at a sliding scale from 6% to 16% on all inherited wealth above that cap.
Spouses, children, all direct descendants of children, spouses of children, parents, grandparents, step-parents and siblings are exempt.
All others are taxed at 10% of all inherited wealth.
Spouses and charities are exempt.
Children, grandchildren, parents, grandparents and siblings: Exempt up to $40,000. Taxed at 1% of all inherited wealth above that cap.
Aunts, uncles, nieces, nephews and cousins: Exempt up to $15,000. Taxed at 13% of all inherited wealth above that cap.
All others: Exempt up to $10,000. Taxed at 18% of all inherited wealth above that cap.
Spouses, domestic partners, civil union partners, children, grandchildren, parents, grandparents, step-children, charities, educational institutions and religious institutions are exempt.
Brothers, sisters, brothers-in-law and sisters-in-law: Exempt up to $25,000. Taxed at a sliding scale from 11% to 16% on all inherited wealth above that cap.
All others: Taxed at 15% on all inherited wealth up to $700,000. Taxed at 16% on all inherited wealth above that cap.
Spouses and charities are exempt.
Children, grandchildren, parents, grandparents, sons-in-law and daughters-in-law: Exempt up to $3,500. Taxed at 4.5% on all inherited wealth above that cap.
Siblings, half-siblings and step-siblings: Taxed at 12% on all inherited wealth.
All others: Taxed at 15% on all inherited wealth.
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