When someone dies, their estate is a distinct legal entity for tax purposes. As a result, estates can be required to pay estate and income taxes. The threshold for federal estate taxes is quite high--$12.92 million for an individual in 2023. If one partner in a married couple dies, their exemption transfers to the surviving spouse, effectively doubling the threshold. That amount includes lifetime gift tax exemptions the individual has previously claimed (the annual gift tax exemption is $17,000 starting in 2023).
Because of the high threshold, less than 0.1 percent of the people who die have estates that end up paying estate taxes. However, since the increases passed with the Tax Cuts and Jobs Act (2017) expire at the end of 2025, the threshold could revert to the previous minimum of $5.49 million, slightly increasing the numbers. If taxes are due, the tax rate is 40 percent.
In addition, some states (Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Rhode Island, Vermont, and Washington, plus the District of Columbia) have state-level estate taxes in various amounts. All these have lower thresholds for triggering the estate tax. However, as with the federal estate tax, spouses can inherit without triggering the charge.
However, many estates don't have to file income tax returns. Some variables may require the executor or other administrator to file. If the estate has a beneficiary who is also a nonresident alien, that triggers the need for a Form 1041, as does the generation of more than $600 in annual income.
On the other hand, if the executor promptly distributes all the assets to the heirs, the estate may not have sufficient income to require the filing. If there is income to report, the executor files the return. Deductions may reduce the taxes due. Such expenses include the executor’s fee, other professional service charges like accountants and attorneys, and probate costs. However, funeral and medical expenses are not deductible.
There is no federal inheritance tax. Heirs do not pay income taxes on amounts they inherit, although six states levy inheritance taxes. The amount of the tax is between zero and 16 percent, depending on the state, the amount of the inheritance, and the relationship between the deceased and the person receiving the bequest. Most of the states that have inheritance taxes include exemptions for close relatives.
If you inherit a trust that distributes income, you may have to pay income taxes on the money you receive. If the money you receive as a distribution is from the trust's principal, you won't owe taxes since the estate or grantor has already paid taxes. However, you will owe applicable income taxes if you receive a distribution from the trust’s interest earnings.