In all our lives there comes a time when we have to say goodbye to a family member or friend. If you were close to the person who died, you may discover that he or she left you something in their last will. Before you officially take over your mother’s house or claim her jewelry, there may be one more thing you need to worry about: an estate tax on your new assets.
A financial advisor can help you minimize estate taxes by creating an estate plan for you and your family. Find a financial advisor today.
What is an inheritance tax?
An estate tax requires beneficiaries to pay taxes on assets and property they inherit from someone who has died. Sometimes inheritance tax is used interchangeably with the term “wealth tax.” Both are forms of so-called death taxes, but they are actually two different types of taxes.
By definition, estate taxes are taxes on a person’s right to transfer ownership of their entire estate to their loved ones when he or she dies. The most important factor here is the value of real estate.
If the value of the transferred assets exceeds the federal estate tax exemption (which is $12.06 million for tax year 2022 and $12.92 million for tax year 2023), the property may be subject to federal estate taxes. States also have their own exemption thresholds. Inheritance taxes are deducted from the property that is transferred before a beneficiary claims it. However, President Joe Biden has proposed eliminating “stepped-up basis,” a provision that resets the value of inherited property to its current market value when the original owner dies.
In inheritance tax, on the other hand, the focus is usually on who the heir is. And while it is possible to owe estate taxes at the state and/or federal level, estate taxes are only collected by states.
Only six states impose inheritance taxes. So if you inherit from someone who lived in one of the following places, your inheritance may be subject to state taxes:
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Maryland
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Nebraska
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Kentucky
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New Jersey
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Pennsylvania
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Iowa
Even if you are an heir and live in one of these states, you are free if the benefactor who left you the inheritance lives in one of the other 44 states.
Who has to pay inheritance tax?
As you can see, there are only six states with estate taxes. In general, estate taxes vary based on the relationship of the beneficiary to the deceased.
Spouses are automatically exempt from inheritance tax. This means that if your husband or wife dies and leaves you an apartment, you won’t have to pay estate taxes at all, even if the property is located in one of the states mentioned above. Since the Supreme Court’s ruling, the same rule applies to same-sex spouses.
Children and grandchildren who receive an inheritance are also not taxed if the deceased lived in one of these four states: New Jersey, Kentucky, Iowa or Maryland. The bad news then is that all other family members – and children and grandchildren who receive property from Pennsylvania and Nebraska – may have to pay.
How much is the inheritance tax?
Here’s an overview of each state’s estate tax:
Rates and tax laws may change from year to year. For example, Indiana once had an estate tax, but it was removed from state law in 2013.
Avoiding inheritance tax
Besides getting married or convincing your family members to move, there are other steps you can take when trying to figure out how to avoid estate taxes.
One option is to convince your relative to give you part of your inheritance money as a gift each year. In 2023, anyone can donate up to $17,000 to someone else in a year and not pay gift taxes. Couples who own property jointly can give away up to $34,000.
As an alternative strategy, you can ask your loved one to set up a revocable trust. This way they can set aside their assets and investments for you and their other beneficiaries without having to worry about inheritance taxes.
When a trust is revocable, the person who put their assets into it can take them out if necessary. On the other hand, once something is placed in an irrevocable trust, it remains there permanently until the person who created the trust dies and everything is passed on to the heirs.
In short
If you’ve lost someone you love, the last thing you want to think about is paying taxes on the assets you inherited. Therefore, if your relatives live in a state that has estate taxes, it may be a good idea to talk to them about trusts and estate planning as soon as possible. There may also be income taxes you have to pay if you inherit an account such as an IRA or a 401(k).
Estate planning tips
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Estate planning can be complicated, so it pays to be prepared. A financial advisor can be a solid resource to lean on. SmartAsset’s free tool matches you with up to three vetted financial advisors serving your area, and you can interview your advisors for free to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Estate planning can be complex, and this is especially true if you are someone with significant assets. To make sure you have everything you need, read up on the essential wealth planning tools for high net worth investors.
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If you want your beneficiaries to avoid a potentially long and costly probate process, consider creating a revocable living trust. This estate planning tool can give you the flexibility you can’t get from other trusts or wills.
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Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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