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We're commonly asked if inheritances are taxed. The short answer is "No, they're not directly taxed at the federal level; and usually not at the state level either....."
But to determine whether your inheritance will be affected by taxes in general, it's important to clearly understand the difference between estate taxes, inheritance taxes, and income taxes. That's because each comes into play upon one's death.
Estate taxes are imposed by the federal government and/or a state (not all states have this tax) on the right to transfer property to heirs after death. Therefore, estate taxes are essentially applied before an inheritance is actually given. The federal estate tax exemption as of 2018 is $5.6 million, meaning no estate taxes are due on any estates valued below this level.
Inheritance taxes are imposed by a state government (there are no federal inheritance taxes) on the right for heirs to receive a deceased person's property. Only six states currently collect an inheritance tax (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania). So if the decedent you're inheriting from didn't live or own real estate in any of these six states, then you won't owe any inheritance taxes (even if you, the inheritor, live in one of these states). Also, each of these states has unique exemption levels applied to those who may have inheritance taxes.
Income taxes are levied by governments (federal and state) directly on income, both earned (wages, salaries, commissions, business, etc.) and unearned (dividends, interest, rents, etc.)
Income tax is the area where your inheritance is most often affected by taxes. That's because certain items in an estate are not passed to heirs totally tax free, even if the cumulative estate value falls under the $5.6 million exemption amount.
So while an inheritance itself is not considered income, the property you inherit may have built-in income tax consequences. For example, if you inherit a 401k, you'll have to include distributions as income on your tax return. But if you inherit cash, there's no income tax. The key is to understand the taxability of the property being inherited. Things like rental properties and stocks may have capital gains tax implications. These items also receive a "step up" in cost basis as of the date of death. So this can help limit the resulting tax upon sale.
Feel free to contact us with specific questions...we're here to help!
The above info may not reflect recent changes in tax laws. Please consult with an accountant or attorney directly for advice.