Leaving an inheritance to your loved ones is an excellent way to care for them after you’re gone. However, you may wonder if your beneficiaries will have to pay taxes on the assets they receive as part of your estate.
The IRS does not tax an inheritance as income; however, it does tax profits gained from the sale of assets or income made from an inherited asset. Additionally, some states levy an inheritance tax on recipients. Gain an overview of inheritance tax law to help you manage your wealth for estate planning.
Inheritance vs. Estate Taxes
When leaving assets to your beneficiaries, it’s essential to understand the difference between an inheritance tax and estate tax. Both tax types are relevant to estate planning but are taxed differently at the state and federal levels.
Estate Tax
The IRS charges an estate tax on the fair market value of all of the assets in your estate. The IRS exempts estates worth under $12.06 million, so most people don’t qualify for the estate tax. If your estate is worth more than the $12.06 million and you qualify, these federal taxes come out of the estate. Estate tax rates increase with the estate’s worth, between 18% and 40% of the taxable amount.
Inheritance Tax
An inheritance tax is a tax on an individual asset a beneficiary receives. Inheritance tax is not taxed as income, but if the asset produces income, for example, an investment property that brings in passive income, the income from the asset is taxed as income.
Your beneficiaries are responsible for paying the inheritance tax on any gifts you leave them in your estate. If they choose to sell the asset in the future, they may have to pay capital gain taxes on the profits.
State Inheritance Tax Rules
Six states levy an inheritance tax, including Nebraska, Kentucky, Iowa, Pennsylvania, and New Jersey. Each state uses different criteria for determining its inheritance tax rate, including the beneficiary’s relationship to you and the asset’s value. Typically, inheritance tax ranges from 1% to 18%, with most states exempting spouses and children.
Some states, like Nebraska, exempt inheritance under a certain amount and allow for exemptions for spouses, children, and other close relatives. For example, assets under $25,000 don’t incur an inheritance tax in Iowa, and Maryland doesn’t levy an inheritance tax for estates smaller than $50,000. In New Jersey, siblings and step-children are only exempt up to $25,000 but may owe between 11% and 16% depending on the asset’s value.
Minimizing Inheritance Tax for Your Beneficiaries
As part of your wealth management strategy, you may wish to minimize inheritance tax for your beneficiaries. Talk to your financial planner and estate attorney to determine the best strategy for your circumstances. Inheritance tax is levied in the state where your beneficiaries reside, so it’s important to consider state-specific rules for estate planning.
Generally, the best way to reduce inheritance tax is to give your beneficiaries assets while you’re alive. You can give up to $16,000 annually ($32,000 for married couples) without incurring the gift tax. This also reduces your estate’s value, lowering the tax liability for the asset. You might also consider placing your assets into a trust to avoid inheritance tax.
