Estate planning is crucial to ensure the capital and assets you’ve spent your career amassing remain with the beneficiaries of your choosing.
When you pass, however, those assets could be subject to inheritance and estate taxes depending on where you lived and how much wealth you left to your beneficiaries.
In this article we’ll take a look at whether beneficiaries have to pay taxes on their trust inheritances, as well as examine state and federal inheritance and estate tax rates.
Federal Inheritance Taxes
Many trust beneficiaries won’t have to worry about the federal inheritance tax since it only kicks in on estates worth $11.7 million for the 2021 tax year. That number jumps to $12.06 million in 2022.
If you are fortunate enough to be left with such a large inheritance, any amount over the thresholds mentioned is subject to the highest federal tax rate, which is 40 percent. However, there are many ways taxpayers and their accountants can reduce this rate. If you do receive an inheritance that’s above those thresholds, you’ll also have to file a Form 706 tax return.¹
State Estate Taxes
Twelve states and the District of Columbia levy estate taxes. Exemptions are much lower than the federal threshold as well – in Oregon, for example, any estate over $1 million is taxed between 10 and 16 percent. Washington state has the highest estate tax, which can be as much as 20 percent.
State Inheritance Taxes
Most states don’t impose a state-level inheritance tax. New Jersey, Nebraska, Iowa, Pennsylvania, and Kentucky all do, however. Maryland, meanwhile, levies both an estate and an inheritance tax.
The rate at which your trust inheritance will be taxed in these select states depends on a few things:
- The relationship between the grantor and the beneficiary
- The amount of the inheritance
- The state where you reside
Surviving spouses, however, won’t have to pay inheritance taxes in each of the aforementioned states. One important item to note is that estate taxes are levied against the estate – beneficiaries don’t have to worry about paying estate taxes. Inheritance taxes, on the other hand, are paid by the beneficiary of the inheritance.
Trust Distributions and Taxation
If you are the beneficiary of a trust and begin receiving distributions, you may have to pay taxes on those funds, depending on how they are dispersed.
If funds are being dispersed from the trust’s interest income, then the beneficiary will be liable for taxes. If funds are dispersed from the trust’s principal, then no taxes will be due (since the IRS assumes this money already has been taxed). If you receive funds that are dispersed from income, you’ll get a Schedule K-1 denoting how much money was dispersed from interest income. You will have to claim this amount on your tax return. If the trust doesn’t disperse all the funds earned from interest in a taxable year, the trust will have to pay taxes on that amount (using Form 1041) rather than the beneficiary.
The Bottom Line
Beneficiaries of a trust inheritance may find themselves liable for taxes depending on how much money they’ve inherited, the state where the trust was formed and administered, and how funds from the trust are dispersed.
If you are unsure about your financial and tax situation after inheriting money from a trust, consult with an experienced financial professional to help clear up whether you’ll owe any federal or state taxes.
Sources:
1. Instructions for Form 706, IRS.gov, https://www.irs.gov/instructions/i706
