Inheritance tax is a state-based tax on assets that you inherit from someone else who has passed away. The person who receives the inheritance must pay this tax.
Each state has its own unique rules and regulations when it comes to inheritance taxes. Some states do not have inheritance taxes at all, while others have somewhat high inheritance tax rates.
Inheritance Tax at the Federal Level
There is no federal inheritance tax because most inheritance is not considered income for tax purposes at the national level. In fact, you generally do not even have to report the inheritance to the IRS in most cases.
However, if the asset you receive produces income, you may need to report that income to the IRS. Some common examples of income-producing assets from an inheritance might include rental property or investments that produce interest or dividends. The income you receive from the inherited property is treated just like any other property that you would have purchased outright.
Estate Tax vs. Inheritance Tax: What’s the Difference?
The federal government (and a few states) have an estate tax. This is not the same thing as an inheritance tax, but there are similarities.
An inheritance tax is a tax on assets that a beneficiary inherited from someone else. It is a tax on the person who receives the asset rather than on the decedent giving the asset away.
An estate tax is a tax that is imposed on the person’s estate after they pass away. It is not a tax on an individual beneficiary. Instead, it is tax on the overall estate, and the amount of the tax varies based on the value of the estate.
The federal government has an estate tax, and some states also have this tax. However, most estates are exempt from this tax. Only estates above $11.17 million in 2021 will have to deal with a federal estate tax. It also does not apply when the spouse receives all of the inheritance from the estate.
States with Inheritance Tax
Inheritance taxes vary by state. Below is a brief outline of which states have the inheritance tax and how much you might have to pay in inheritance tax.
In Iowa, you must file an inheritance tax return if you received an inheritance. The return must be filed, and the tax owed must be paid by the ninth month after the decedent’s death. You can sometimes get extensions for the return, but there is an application process for this request.
Iowa has a sliding scale rate that varies based on the size of the inheritance. The rate will vary between 5% and 10%. As the inheritance goes up, so will the rate of the tax. However, Iowa has quite a few exemptions that can be applied to decrease or avoid inheritance taxes. For example, inheritances passed to certain individuals, including spouses and children, may not be taxed. If the entire estate is valued at less than $25,000, you will not be taxed.
Kentucky permits a 5% discount to those who pay their inheritance tax within nine months of the date of the decedent’s death. However, the return does not actually need to be filed until 18 months after the decedent’s death. Beneficiaries might also be able to set up payment plans for the total amount of the inheritance tax due as well.
Kentucky’s inheritance tax rates vary between 4% and 16%, depending on who the beneficiaries are and how much the total inheritance may be. Spouse and children beneficiaries, along with a few other categories, are exempt from inheritance taxes in Kentucky.
Maryland requires payment of inheritance taxes within nine months of the decedent’s death. An estate tax return is not required for every estate—only those that exceed certain value amounts. The inheritance tax in Maryland is a flat 10%. However, Maryland is also the only state with an estate tax and an inheritance tax.
Spouses, children, parents, grandparents, stepchildren, siblings, and a few other categories of beneficiaries are exempt from inheritance tax.
Nebraska’s inheritance tax is much broader compared to other states. In fact, even life insurance that is passed through the estate is taxed under Nebraska’s inheritance tax rules. Unlike other states, Nebraska does not have inheritance tax exceptions for children and other relatives. Only passing assets to a spouse will allow you to avoid Nebraska’s inheritance tax.
However, calculating the inheritance tax is more lenient in Nebraska, depending on the category of beneficiary. For example, if the beneficiary is a parent, grandparent, child, or sibling, the effective tax rate is only 1%. It also only applies to inheritances over $40,000. However, more distant relatives may see a tax rate of up to 13%, and non-relatives have to deal with a tax rate of 18%.
In New Jersey, spouses, civil union partners, domestic partners, children (including legally adopted children and stepchildren), grandchildren, parents, and grandparents are all exempt from inheritance tax. If you are a more distance relative, you may face taxes of up to 16% if the estate’s value is over $1,700,000. If the value of the estate is under $25,000, no inheritance tax will be imposed.
Tax returns are required to be filed and paid within eight months of the decedent’s death.
Pennsylvania also makes certain exceptions to inheritance tax depending on the beneficiary’s relationship to the decedent. For example, there is no tax on transfers to a spouse or to a parent, if the decedent is a child under 21 years old. However, there is a 15% tax on transfers to more distant heirs. Charitable organizations are exempt from this tax. The tax rate will vary based on the relationship to the decedent. Some farmland in Pennsylvania is also exempt from the inheritance tax. If it is imposed, the tax is due to be paid within nine months after the decedent’s death. If the tax is paid within three months of the decedent’s death, then there is a 5% discount on the total tax.
Is Your Inheritance Subject to State Tax? How to Calculate Inheritance Tax
Because each state varies in whether an inheritance tax is imposed and how much that rate is, state law will have a huge effect on how inheritance tax is calculated.
Keep in mind that inheritance tax is based on the state in which the decedent passes away, not necessarily where the asset that is being transferred is located.
In general, you should take the following steps to calculate the inheritance tax.
1. Determine your classification of exemption.
Because many states offer exemptions to certain relatives, you should determine whether you qualify for one of these exemptions first. Your classification will also dictate what tax rate you should use to calculate the total inheritance tax as well.
2. Determine the value of the inheritance.
If the inheritance is a fund or money asset, then the value will be easy to calculate. However, if the asset is real or personal property, you may need to get an appraisal or evaluation before you can determine the tax obligation.
3. Fill out the inheritance tax form and compute the inheritance tax.
Each state has a separate inheritance tax form that you can use to calculate the total inheritance tax owed.
Avoiding State Inheritance Tax
The best way to avoid state inheritance tax is to ensure that all of your gifts are going to exempt individuals. Your spouse is exempt in every state, but others may be exempt as well.
Suppose your beneficiary is not an exempt individual. In that case, you may want to consider giving them periodic gifts while you are alive, rather than waiting to pass the assets on after your death. As of 2021, anyone can gift another person up to $15,000 per year without having to pay a gift tax. Married couples can provide gifts of up to $30,000 in some situations.
How Dechtman Wealth Can Help with State Inheritance Taxes
Inheritance tax is certainly not the only tax you should think about as you are planning your estate. Instead, a wide range of financial implications may affect you and your loved ones after you pass.
Talking to a wealth management team can be a good way to help you create your estate plan. Dechtman Wealth can help you ensure that as much as your gift as possible is actually going to your beneficiary—rather than going to the state or federal government in tax bills. Call today to get more information or to set up an appointment.
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