How to minimize your tax bill on an inheritance
If a loved one passes away and leaves you an inheritance, or makes you the beneficiary of their life insurance policy, you may be wondering what comes next. Although for some, receiving a large sum of money or assets can be emotionally difficult, an inheritance can be the financial relief one needs to get back on their feet or to pay down significant debt.
To do that, it is important to understand the tax implications of the gift you’ve been given and the taxation rules you must follow. It may also be a good idea to consult with a tax attorney who specializes in issues related to inheritance.
After all, your loved one wanted you to have this gift, and you can honor that gesture by doing some homework to make sure you will be a good steward of the funds.
Types of taxes on an inheritance
When it comes to possible inheritance taxes that can pop up on your tax bill, there are three: inheritance tax, capital gains tax, and estate tax.
If you’re concerned about what you’ll find on your tax bill when you receive an inheritance, it all comes down to what type of inheritance and the federal and state laws attached to it.
When you receive an inheritance, the first thing you want to do is look at your state’s laws surrounding inheritance.
Although estate and capital gains taxes are imposed by the IRS, state taxes vary. As of 2022, only six states in the U.S. have a mandatory inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Only six states in the U.S. have a mandatory inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
Inheritance tax is based on the value of assets and a threshold amount that changes every year. You only have to pay tax on what exceeds the threshold. For example, in a state where the threshold is $2 million with a 5% inheritance tax, a person who inherits $5 million can expect to pay 5% on $3 million of it.
However, depending on your relationship with the person who passed away, you won’t have to pay inheritance tax or there will be a reduction. Generally, spouses, children, and other dependents are exempt from having to pay tax on inheritance, no matter where they reside.
Capital gains tax
If you inherit an asset, for example a piece of property, and sell it, that’s where a capital gains tax comes into play but only on the “stepped-up in basis value.”
For example, if a grandparent passes away and leaves you a house that’s worth more than what they originally paid for it, that’s the stepped-up in basis value.
If you decide to sell it and are able to sell it for more than what it was worth when your grandparent passed away, then the capital gains tax will be paid on that extra amount.
Capital gains taxes exist at both the state and federal level, so you can expect to pay a sliding scale amount based on your income. If you live in a state that doesn’t have income taxes, then you don’t have to worry about paying the capital gains tax on anything you sell.
If you inherit an entire estate, the tax will be based on the total value of all your loved one’s assets—property and money. The tax amount comes out of the estate and is determined before distribution of any of the assets can begin.
Similarly to state inheritance tax, there’s a threshold. At the federal level, that threshold is $11.7 million. If the estate exceeds that, then 40% of the estate’s total value will end up going to the IRS.
On the state level, as of 2022, only 12 states plus Washington, D.C. impose an estate tax. The threshold for estates and the percentage that’s imposed vary from state to state. But, in most cases, if the estate is less than $1 million, there won’t be any taxes on it.
How to manage those tax implications
No matter what type of inheritance you receive, managing that money or assets in a way that allows you to lessen your tax bill is something that’s likely to come up.
Although an estate tax comes from the estate, the same can’t be said for inheritance and capital gains taxes—those are taxes you pay on what has been passed down to you by your loved one.
Should you live in one of the six states that imposes inheritance tax and the amount you received exceeds the state-mandated threshold, there are ways you can protect it—if you are able to have frank conversations with your loved one about estate planning while they are alive.
For example, you can ask them to put the funds in a trust. That way when your loved one passes away, it will go directly to you without having to go through probate.
Another option is asking your loved one to take out a life insurance policy in the sum that will be left to you because death benefits aren’t taxed.
If there is a lot of money to be inherited, you can also request that your loved one “gift” it during their lifetime. The IRS allows up to a $16,000 gift to an individual person every year, with no limits as to how many recipients of these $16,000 gifts can be given.
The amount can be given once a year in a lump sum of $16,000, or in smaller increments that equal $16,000 within one year.
If you were unable to pre-arrange these situations, however, you have other options: Making charitable donations or financial gifts to loved ones will decrease your overall tax liability.
Capital gains tax
A way to protect your inheritance if it comes in the form of property or an asset you plan to sell, is by choosing an alternate valuation date for the item(s).
Although when someone passes away the value of the property is based on the fair market value on that date, in some cases (if you’re the executor), you can change the valuation date for six months after the death. However, this option is only allowed if the alternate date will decrease the gross amount of both the property and estate tax liability.
Unless your loved one left behind a large estate or you live in Washington, D.C., or one of the 12 states that imposes estate tax, there’s a good chance you won’t have to worry about estate taxes. You also don’t have to really worry about them because if there are taxes, they’ll come directly out of the estate before any other assets can be distributed to you or anyone else.
If you receive an inheritance of any kind, it’s important to realize there are exceptions and exemptions that can lessen your tax bill. It’s also important not to rush into making any rash decisions about that inheritance. Grief can cause people to do things they wouldn’t normally do, so it’s OK to take your time and wait until you feel emotionally strong enough to make reasonable decisions.
Once you’re ready, you can take a look at what you’ve inherited and what taxes you can expect on your tax bill. From there, you can take your next steps.
Finally, it’s always advisable to seek out the advice of an estate attorney experienced with tax issues, to make sure you understand all of your options and are making the best decisions for your financial future.
You may be eligible for free bereavement support. Empathy can help with everything from funeral planning to estate administration, with step-by-step guidance and real-time expert support. Many people get free premium access to Empathy as a benefit with their life insurance claim. We partner with New York Life, Guardian Life Insurance Company, Bestow, Lemonade, and other leading carriers. When you make your life insurance claim, talk to your representative about whether Empathy is a benefit they offer.
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