Inheriting cash, property, or investments could trigger a tax that effectively reduces the value of your windfall.
Known as the inheritance tax, it’s levied by certain state governments rather than the IRS.
What is a Inheritance Tax and How Does it Work?
There is no federal inheritance tax in 2022. Instead, the U.S. government charges an estate tax on the value of transferred property at an individual’s death.
Owing an estate tax is rare because the exemption limits are so high. The federal tax only kicks in when an estate is valued at more than $12.02 million — or $24.12 million for married couples who file taxes jointly — in 2022 (some states also tax estates and have lower exemption limits).
Other federal taxes that often fall under the umbrella of inheritance taxes but are fundamentally different are capital gains taxes and income taxes, which you might pay on inherited assets like stocks or retirement account distributions.
Read More: Estate Planning Primer: Trusts and Estates
Who Pays an Inheritance Tax?
People who live in states with an inheritance tax may have to pay a tax on the value of their inherited property that exceeds a certain exemption amount. Practically, this means they’ll get less than the amount that was left to them.
Spouses and blood relatives of the decedent are generally either exempt from inheritance taxes or pay a very low rate.
States that Charge an Inheritance Tax and Their Rates
As with most tax laws, so-called “death taxes” are hotly debated. Only six states impose an inheritance tax in 2022, describing it as a tax on the “privilege” or “right” of receiving property, but the list is shrinking.
Iowa lawmakers have voted to eliminate the inheritance tax and will be phasing it out by 2025. There’s a proposal making its way through the Nebraska state legislature that would lower its inheritance tax rates and increase the property exemption. If approved, the changes would take effect on January 1, 2023.
Inheritance Tax Rates for 2022
4% to 12%, subject to phaseouts
4% to 16%
1% to 18%
11% to 16%
4.5% to 15%
Inheritance tax rates in each state vary depending on the type and value of the property and the person’s relationship to the person who died. Most states require a beneficiary to pay any tax owed within nine months of the date of death.
Inheritance Taxes vs. Estate Taxes
An inheritance tax is different from an estate tax because it’s levied on the property someone receives when another person dies. An estate tax is levied on the estate itself.
There is no one person responsible for paying the estate tax; rather, it’s taken out of the estate before the wealth passes to the decedent’s heirs, unless it’s their spouse. An inheritance tax must be paid by the person receiving the property.
Capital Gains Tax
While there’s no federal inheritance tax, beneficiaries may still owe taxes to the IRS (and/or their state government) on inherited capital assets, such as real estate or stocks, when they make a sale. Luckily, the IRS allows beneficiaries to use a “stepped-up basis” to calculate any capital gain, which often results in a lower tax.
Here’s an example: Let’s say a woman bought 100 shares of Company XYZ for $1,000 in 1999. When she died in 2021, she left the shares, now valued at $10,000, to her grandson. He held on to the shares for another year before selling them for $12,000. To calculate his capital gain, he needs to subtract his basis from the sale price ($12,000 – $10,000 = $2,000).
Since he inherited the shares upon the original owner’s death, his basis is the fair market value on that day. Had his grandmother gifted the shares to him before she died, the grandson would have carried over her basis of $1,000, resulting in a much higher capital gains tax.
Read More: Capital Gains Tax 2021 and 2022 Rates
Tips for Mitigating Inheritance Taxes
Inheritance tax rules vary by state and can get complex. In general, it’s rare to owe a huge tax on inherited property. One reason is because states don’t levy the inheritance tax on spouses or direct descendents, including children and grandchildren. Also, several states don’t tax inherited property until it exceeds a certain threshold. For example, in New Jersey, the sibling of a decedent won’t be taxed on an inheritance under $25,000.
People who plan to leave wealth to extended family or friends can plan ahead in order to mitigate the inheritance tax for their heirs. Lump sum proceeds from a life insurance policy, for example, are usually not taxable to the beneficiary or beneficiaries.
One way to avoid an inheritance tax completely is to make gifts during your lifetime rather than transferring property at death. In 2022, you can give up to $16,000 to an unlimited number of people without triggering a gift tax.
The Bottom Line
Managing your taxes is one part of your overall financial plan. You can take a few actions now to get yourself on the right track.
Download 5 Tax Hacks for Investors, an actionable guide with insights from fiduciary financial advisors. The guide is free.
Sign up for the Personal Capital Dashboard. Millions of people use these free and secure professional-grade online financial tools. You can use them to see all of your accounts in one place, analyze your spending, and plan for long-term financial goals.
Consider talking to a fiduciary financial advisor for more detailed guidance on your financial plan.
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Author is not a client of Personal Capital Advisors Corporation and is compensated as a freelance writer.
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