NOTE: Tax laws change frequently and the following information may not reflect recent changes in those laws. For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
A common question that comes up when I speak with the beneficiary of an estate or trust is whether or not the beneficiary will have to pay any taxes on their inheritance. Before this question can be answered, the beneficiary needs to understand that the term "taxes" actually encompasses three different types of taxes: inheritance taxes, estate taxes and income taxes.
Whether or not your inheritance will be subject to inheritance taxes, estate taxes and/or income taxes will depend on many factors, so let's tackle each of these types of taxes separately.
State Inheritance Taxes
The good news for most beneficiaries is that they will never have to worry about inheritance taxes because at this time only six states collect them - Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. In addition, in all of these states property passing to a surviving spouse is exempt from inheritance taxes, and only Nebraska and Pennsylvania collect inheritances taxes on property passing to children and grandchildren.
So, if the decedent didn't live in Iowa, Kentucky, Maryland, Nebraska, New Jersey or Pennsylvania or own real estate in any of these states, then you won't owe any inheritance taxes. This is true even if you, the person receiving the inheritance, live in one of these six states. And even if the decedent lived in one of these states or owned real estate in one or more of them, then you may or may not owe inheritance taxes depending on your relationship to the decedent. In addition, usually inheritance taxes will have to be paid before you can be paid your inheritance check, so the amount that you receive will already be reduced by the taxes that are paid.
My State Inheritance Tax Chart gives a brief overview of the inheritance tax laws in the six states that collect them, while the links provided above associated with each state name give detailed information about the inheritance tax laws of each state.
State Estate Taxes and Federal Estate Taxes
The good news is that for federal estate tax purposes the 2013 estate tax exemption is $5,250,000 and the 2014 estate tax exemption will be $5,340,000. Thus, if the decedent's estate is valued under the applicable exemption amount in the year of death, then you won't owe any federal estate taxes.
With regard to state estate taxes, currently only a handful of jurisdictions collect them - Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont and Washington. So, as with state inheritance taxes, if the decedent didn't live in any of these states or own real estate in any of these states, then you won't owe any state estate taxes even if you, the person receiving the inheritance, live in one of these states.
On the other hand, if the decedent lived in one of these states or owned real estate in one or more of these states, then the value of the estate must exceed the state estate tax exemption before any state estate taxes will be owed. Currently the state estate tax exemptions range from a low of $675,000 in New Jersey to a high of $5,250,000 in Delaware and Hawaii (which will increase to $5,340,000 in 2014, just like the federal estate tax exemption). But even if the estate will owe state estate taxes, usually these taxes will have to be paid before you can be paid your inheritance check, so the amount that you receive will already be reduced by the taxes that are paid.
My State Estate Tax and Exemption Chart lists the current state estate tax exemptions in the jurisdictions that collect them, while the links provided above associated with each state name give detailed information about the estate tax laws of each state. In addition, my 2013 State Death Tax Chart list the exemptions along with the top death tax rates.
State Income Taxes and Federal Income Taxes
In general an inheritance in and of itself is not considered income, so you won't have to report your inheritance on your state or federal income tax return.
However, the property that you inherit may have built in income tax consequences. For example, if you inherit a traditional IRA or 401(k), then you will have to include all distributions you take out of the IRA or 401(k) in your federal income, and possibly your state income, during the year in which you take the distributions.
Aside from retirement accounts, if you inherit stocks that are held outside of an IRA or 401(k) or real estate, then when you go to sell the stock or real estate you may have to pay capital gains taxes based on the difference between the inherited value of the property (which receives a "stepped up basis" as of the date of death) versus the sales price that you receive. For example, if you inherit a house that is valued at $100,000 on the decedent's date of death but you turn around and sell the house for $150,000 a few years later, then you will owe capital gains taxes on $50,000.
A Note About Gifts and Inheritances Received From Foreigners
If you are a U.S. citizen or a resident alien and you receive a gift or inheritance from a foreigner, then you need to be aware that there are specific reporting requirements that must be followed for federal tax purposes with regard to the foreign gift or inheritance: Do You Have to Report Gifts or Inheritances Received from Foreigners to the IRS?
The Bottom Line on Taxes on Your Inheritance
There are many misconceptions about taxes and inheritances. If you are not sure if you will have to pay taxes on your inheritance, then consult with an estate planning attorney to be sure.