It’s not something we like to think about, but when friends and loved ones die, they may leave you an inheritance. Like any income, you probably assume you’ll pay income taxes on the money.
The good news is there aren’t federal taxes on inheritance funds, at least that the beneficiary must pay. There are certain situations you should understand, though, that can affect your income and tax returns.
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Estate Taxes
When a person dies, they have an estate or the total of their assets. The estate itself will be responsible for federal income taxes. The executor of the estate pays the taxes from the estate; they do not have to pay it from their inheritance.
The estate taxes must be paid first from the estate. How much federal tax the estate owes depends on the balance. There’s good news, though.
The IRS offers an estate tax exemption. Any estate that’s worth less than $11.7 million does not owe estate tax. Any amount over the $11.7 million, however, is taxable.
For example, if an estate is worth $13 million, the estate would owe taxes on the $1.3 million difference which is taxed at 40%. If the difference is say $5,000, the estate would pay 18% tax.
Inheritance Tax
Inheritance tax is different. Individuals or beneficiaries who receive the income pay inheritance tax. Fortunately, there isn’t a federal inheritance tax, but some states charge it including:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
The state tax rate varies by state, for example, Nebraska charges 1% – 18% inheritance tax depending on the amount inherited and Pennsylvania charges 4.5% – 15%.
Capital Gains Taxes
In some cases, you won’t receive cash as your inheritance but may instead receive it as an investment, such as stocks, bonds, or even real estate. Like any investor, you may owe taxes on your capital gains or profits.
You won’t owe any capital gains taxes until you sell the asset or property and it works a little differently than when you buy an asset yourself.
Instead of determining your capital gains based on the original value the deceased purchased the asset, you can use the ‘stepped up’ value or the value of the asset the day the owner passed away.
When you sell the asset, you’ll owe taxes on any profits you made from the date the asset was transferred to you and the price you sell it. This could mean you pay little to no capital gains taxes depending on the price when you sell.
Inheriting Retirement Accounts
If you inherit retirement accounts, you may owe taxes on the funds depending on how you receive them and the type of account.
- Traditional IRA – If you receive a traditional IRA as an inheritance, you must withdraw the minimum required distributions either the year your loved one died or the following year. You’ll pay taxes on any funds withdrawn since the funds were contributed before taxes, so the money hasn’t been taxed yet.
- Roth IRA – If you receive a Roth IRA, the funds have already been taxed since the tax benefits of a Roth IRA are during retirement and not when you contribute the funds. If you inherit a Roth IRA, you aren’t subjected to Required Minimum Distributions or taxes on the amount you withdraw.
- Spousal expectations – If your inheritance comes from a spouse, you can roll the IRA over into your IRA to defer the taxes until you retire and withdraw the funds. You’ll then pay taxes at your tax rate during retirement (which may be lower).
Other Exceptions
Aside from capital gains taxes, there may be other tax situations you incur after receiving an inheritance including:
- Renting out an inherited house – If you inherit a house and keep it, you won’t owe taxes on anything until you sell the house unless you rent the home out. If you make monthly cash flow, you must report the income and pay taxes as you would if you bought the home yourself.
- Earned interest – If you inherit a bank account and the money earns interest, you must report the interest on your tax returns.
- Dividends – If you inherit dividend paying stocks, you must report the dividends earned from the day you inherited the stocks.
How to Prove Funds are an Inheritance
The IRS doesn’t receive notice of your inheritance like they do any income you earn from an employer or investment, but it’s your responsibility to report the income if it exceeds the federal threshold.
If you get audited and need to prove the money you have is from an inheritance and not earned income, you may need proof of the funds. Keep copies of any documentation you receive from the inheritance including:
- Death certificate
- Will
- Transfer of ownership forms
- Any official letters from the estate owner or the courts
Keep in mind, if you inherit property or assets (stocks/bonds), you may have to report ownership of them if you earn any income from them such as rental income, capital gains, or dividends.
Bottom Line
Understanding how you may receive an inheritance can help you plan your taxes. Most people won’t be subjected to inheritance tax unless they live in one of the six states mentioned or you make earnings after receiving the inheritance.
Talk with your tax advisor about how to best structure your investment so you know how to manage your inheritance. For example, if you inherit property and plan to keep it, talk to your advisor about the tax consequences of the rental income and how you can offset it (writing off business expenses).
Overall, you shouldn’t owe too much in taxes on an inheritance, but always check to ensure you are following the IRS rules and aren’t inadvertently filing your taxes incorrectly because of the inheritance.
