Some states charge the beneficiaries of inherited assets an inheritance tax. Unlike an estate tax, which the decedent’s estate pays, an inheritance tax is paid by the beneficiary of a legacy. Inheritance tax is paid by the person who receives the assets, and rates might change depending on the size of the inheritance and the inheritor’s relationship to the deceased.
The main distinction between the estate and inheritance taxes is who pays the tax. Before any assets are distributed to recipients, an estate tax is deducted from the worth of a deceased person’s cash and assets.
The tax is uncommon in the United States, and as of 2022, the value of the inheritance, the relationship between the beneficiary and the decedent, the state in which the deceased resided or owned property, and whether it applies in one of the six states with an inheritance tax will determine whether it does or does not.
As of 2022, six states—Iowa, Kentucky, Nebraska, New Jersey, Pennsylvania, and Maryland—collect an inheritance tax in addition to an estate tax. Meanwhile, the inheritance tax in Indiana was eliminated on January 1, 2013, and Iowa intends to do the same by January 1, 2025.
An inheritance tax is assessed on the value of the inheritance received by the beneficiary, as opposed to the estate tax, which is assessed on the value of an estate and paid by it.
The size of the inheritance and your relationship to the deceased will determine whether you must pay inheritance tax; smaller sums received from close relatives are more likely to be excluded.
By leaving money to heirs through trusts, and insurance policies or by making gifts during one’s lifetime, inheritance taxes can be reduced or even completely avoided.
How to Calculate Inheritance Taxes
Only the portion of an inheritance that exceeds an exemption level is subject to an inheritance tax if one is required. Tax is typically applied on a sliding scale above such levels. Rates usually start in the low single digits and increase to between 15 and 18 percent. More so than the size of the assets you are receiving, your relationship with the deceased may affect both the exemption you obtain and the rate you pay.
Generally speaking, the larger the exemption and the smaller the cost you’ll pay, the closer your familial connection to the deceased was. In all six states, surviving spouses are immune from inheritance taxes.
Ways to Protect Your Inheritance from Taxes
Consider the alternate valuation date
The alternate valuation is only accessible if it will reduce the estate’s gross value and the estate tax liability, which frequently means that the beneficiaries will receive a more considerable inheritance.
Any asset disposed of or sold during that time frame is valued on the day of the transaction. The date of death serves as the valuation date if the estate is not subject to estate tax.
Put everything into a trust.
Encourage your parents or other family members to create a trust to manage their assets if you anticipate receiving an inheritance from them. A trust enables you to avoid the probate process when transferring assets to beneficiaries after your passing. Wills and trusts are similar, but trusts typically circumvent state probate laws and related costs.
Minimize retirement account distributions
Retirement assets that are inherited are not taxed until they are dispersed. However, if the beneficiary is not a spouse, specific regulations might apply when the distributions must take place.
Give away some of the money.
Sometimes it makes sense to leave some of your fortunes to others, even though it may seem counter-intuitive. You might potentially use the tax deduction you obtain for donating to a nonprofit organization to offset the taxable gains on your inheritance in addition to aiding others in need.
Even though there are several exclusions and exemptions from inheritance taxes, particularly for spouses and children, residents of states that have them may still seek to reduce the exposure for heirs.
One popular method is to purchase a life insurance policy in the amount you want to leave as a legacy and name the beneficiary of the policy as the person you wish to receive it. Inheritance taxes do not apply to an insurance policy’s death payout.