What You Need to Know About Inheritance Tax
When a loved one passes away and leaves assets to beneficiaries, those assets may be subject to an inheritance tax, depending on the location of the deceased and their relationship to the inheritor. Inheritance tax is imposed by the state in which the decedent lived—only six states currently impose it—and is the responsibility of the inheritor. Rules and rates vary from state to state, but blood relatives generally pay a lower inheritance tax rate than friends who aren’t related to the deceased.
What is inheritance tax?
Inheritance tax is a state tax a beneficiary pays when they inherit assets like money or property after the death of a loved one. There is no federal inheritance tax in the U.S. and, as of 2021, only a handful of states impose an inheritance tax to beneficiaries. The tax is assessed by the state where the decedent lived.
If the recipient lives in a state with inheritance tax, that has no effect on whether or not the tax is imposed. The inherited assets will only be taxed if the decedent lived in a state that imposes an inheritance tax. Additionally, even if the decedent lived in one of these states, the inheritance may be exempt—or, at the very least, the beneficiary may be able to get a reduction in the amount of tax they pay, depending on their relationship to the decedent.
States that impose inheritance tax
Currently, the only six states with inheritance tax on some inherited assets are:
- New Jersey
Each state’s inheritance tax range is different, as are the exemption amounts. For example, Kentucky imposes up to a 16% inheritance tax rate on assets worth $1,000 or more, while Nebraska imposes up to an 18% tax rate on $40,000 and up. In Iowa, beneficiaries won’t need to pay inheritance tax unless their inherited assets value more than $25,000.
Exemptions for inheritance tax
Rules and rates vary from state to state, but blood relatives will usually pay a lower inheritance tax rate than friends who aren’t related to the deceased. Direct descendants—like children and grandchildren, for instance—are exempt from inheritance tax if the decedent lived in Iowa, Kentucky, Maryland, or New Jersey. Direct descendants are subject to inheritance tax at rates ranging from 1%-4.5% in Nebraska and Pennsylvania. Surviving spouses are typically exempt altogether.
How inheritance tax works
When the owner of the estate passes away, the estate’s executor is responsible for dividing up its assets and distributing them to the chosen recipients. If the decedent lived in a state that has inheritance tax—and if the inheritor or assets are not exempt—then the inheritor is responsible for paying the tax, usually within nine months of the owner’s death. The state imposing the tax calculates the amount owed by adding up the fair market value of the estate’s assets at the time of the owner’s passing.
When inherited assets are taxable
Here are some examples of types of assets that may be subject to inheritance tax:
- Bank accounts
- ETFs, mutual funds, stocks, and bonds
- Real estate
- Cars, boats, and other motor vehicles
- Art, antiques, and jewelry
- Collectible items
Each of the six states that impose an inheritance tax have a different exemption threshold and associated rules, so it’s best to consult with an attorney to understand which assets are taxable and for how much.
Inheritance tax vs. estate tax
The major difference between inheritance tax and estate tax is who is responsible for paying the tax. With inheritance tax, the recipient inheriting the assets is responsible for paying. However, estate tax is paid by the owner’s estate before assets are distributed to beneficiaries.
Another difference is that estate taxes are imposed at a federal level, as well as by some states—as of 2021, 11 states plus Washington, D.C. Federal estate taxes are only imposed on estates whose values exceed the exemption threshold of $11,700,000 (or $23,400,000 for a married couple). Estates subject to this federal tax owe 40% on whatever surpasses that threshold.
Inheritance taxes, of course, are only imposed by six states currently. Maryland is the only state that has both estate tax and inheritance tax.
How to minimize or avoid inheritance tax
The most effective way to minimize your tax burden—or that of your loved ones—is to use gifting strategies and financial tools like trusts.
Gifting cash—or other assets like stocks, automobiles, or collectibles—can help you start distributing your assets ahead of time. In 2021, the maximum non-taxable gift amount you can give is $15,000 to an individual. To ensure you’re using the right gifting strategies, be sure to get help from a qualified estate planning professional.
Another great option is setting up a revocable trust to put aside investments and property for future recipients. Revocable trusts keep assets accessible if you need to take them out for whatever reason. Irrevocable trusts, as their name suggests, mean that your assets are in the trust until the owner’s death.
One last thing: Understanding capital gains tax
In addition to inheritance tax and estate tax, you also want to consider the capital gains tax. If a beneficiary sells inherited assets that have appreciated in value since disbursement, they may be required to pay capital gains tax on the profits.
Different states have different rules, and beneficiaries may also need to pay state income tax on distributions from inherited 401(k) accounts or IRAs because those assets create taxable ordinary income.
When it comes to inheritance tax law—and all the intricacies associated with it—talking to a financial advisor can help set you, your estate, and your beneficiaries up for success.
Talk with a Local Advisor
Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered or is excluded or exempted from registration requirements.
All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Content, research, tools and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors.
Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark.
This document may contain forward-looking statements including statements regarding our intent, belief or current expectations with respect to market conditions. Readers are cautioned not to place undue reliance on these forward-looking statements. While due care has been used in the preparation of forecast information, actual results may vary in a materially positive or negative manner. Forecasts and hypothetical examples are subject to uncertainty and contingencies outside Mercer Advisors’ control.