Losing a loved one is always incredibly difficult, and the grieving process is long and complicated. However, one bright spot can be receiving an inheritance. It is important to remember, though, that there are possible tax implications related to an inheritance. Those implications vary depending on the size of the inheritance, the type of assets being inherited and the state in which you live.
Do not be too quick in going out and spending any inheritance you receive. It is a good idea to first check into any possible tax implications and work out a plan to minimize any taxes you may owe on the inheritance.
The American federal government does not levy any inheritance taxes and income taxes are not typically paid on any inheritances.
Most states do not collect inheritance taxes either. The exceptions, as of 2018, were Pennsylvania, New Jersey, Nebraska, Maryland, Kentucky, and Iowa. These states impose an estate tax for any individuals who live in their state. If you loved one lived in one of the other 44 states, you will not have pay the inheritance tax even if you do live in one of these states.
An inheritance is not taxable income, so does not have to be reported on your federal or state income tax returns. However, there may be some income tax implications depending on the type of property you inherited, such as a 401(k)s or IRAs.
Capital Gains Tax
The capital gains tax applies to the difference between the current fair market value of the inheritance and the amount for which you sell it. This tax is only applied if you sell the asset at a profit.
Inheritors will be charged federal estate taxes if the estate is worth more than $11.2 million. As most estates do not come anywhere near this dollar amount, the majority of inheritances will not be charged an estate tax.
However, 12 different states in the US do collect estate taxes if the deceased resided within their borders. These states include Washington, Vermont, Rhode Island, Oregon, New York, Minnesota, Massachusetts, Maryland, Maine, Illinois, Hawaii, and Connecticut. The estate must pay any owing state estate taxes before any assets are distributed to the heirs.
Implications of Inheriting Some Specific Assets
401(k)s or IRAs
If the inheritor is the spouse of the deceased, he or she can possibly roll the funds over into their own account. On the other hand, a spouse could also open a Beneficiary or Inherited IRA account. This type of account is listed in both spouses’ names and allows the surviving spouse to withdraw funds from the account without incurring a 10 percent penalty for early withdrawal.
However, other heirs such as children, siblings, etc. do not have the same options but can hold the money in an Inherited IRA account.
How quickly you withdraw the funds can have strong tax implications. Withdrawing funds immediately can result in steep tax charges up to 40%, depending on where you live. While the rules vary, it is typically advisable to take out only the required minimum distributions.
Stocks or Mutual Funds
If the asset does not have a stated beneficiary, then it will have to go through the probate process. The good news is that these assets are treated with the step-up basis. According to the step-up basis, the basis value of any inherited asset is based on the fair market value at the time of the deceased’s passing, and not at the original value. Essentially, this means that if your parents bought a stock valued at $5 per share, which is now valued at $40 per share, you would only pay capital gains tax based on the amount you sell the stock for less the $40, rather than the $5.
Inheriting a house follows the same rule as inheriting stocks or mutual funds.
Inheritance and tax rules vary from state to state, so it is always a good idea to consult a professional to determine if your inheritance comes with any possible tax implications.