Whether someone is receiving an inheritance or is planning to pass their assets down to their loved ones, one of the biggest questions that arises is whether that inheritance will be subject to taxes.
It’s true that, in some cases, the assets in someone’s estate could be subject to various types of taxes. However, taxes usually only apply to large estates, meaning most families aren’t affected. Keep reading to learn how taxes on inheritances work, the different types of taxes that apply, and how to manage that tax liability.
The 4 main types of taxes on inheritances
There are three primary taxes that could apply to an inheritance: estate taxes, inheritance taxes, and capital gains taxes.
Estate tax
The estate tax is a federal tax imposed on property transferred after the owner’s death. The tax is owed by the estate, not by the beneficiaries. In other words, by the time you receive your inheritance, the estate taxes will typically have already been paid.1
Many people worry about the estate tax affecting the inheritance they pass along to their children, but it’s not a reality most people will face. In 2024, the first $13,610,000 of an estate is exempt from taxes, up from $12,920,000 in 2023.
Estate taxes are based on the size of the estate. It’s a progressive tax, just like our federal income tax. That means that the larger the estate, the higher the tax rate it is subject to. Rates range from 18% to 40%.
There are also a handful of states that impose a state estate tax.2Those states are:
- Connecticut
- District of Columbia
- Hawaii
- Illinois
- Maine
- Maryland
- Massachusetts
- Minnesota
- New York
- Oregon
- Rhode Island
- Vermont
- Washington
Each state has its own estate tax percentage and exemption. Oregon imposes an estate tax on all estates larger than $1 million, while Connecticut matches the federal estate tax exemption. Rates vary by state but go as high as 20%.
Inheritance tax
An inheritance tax is a tax that’s imposed on the recipient of an inheritance rather than the estate itself. The federal government doesn’t have an inheritance tax, but a handful of states do. Those states are:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
Iowa is in the process of phasing out its inheritance tax. It will no longer apply to deaths in 2025 or later. On the other hand, just one state, Maryland, imposes both an estate tax and an inheritance tax. In other words, both the estate and its beneficiaries must pay taxes on the assets transferred after a death.
Who is subject to inheritance taxes and how much they’ll pay varies by state. Each state has certain exemptions in place, just like the IRS does for the estate tax.
In some cases, the exemption differs depending on someone’s relationship to the deceased. For example, a close relative such as a spouse, child, parent, or sibling might pay no inheritance taxes at all. Meanwhile, there might be exemptions in place from more distant relatives. In other states, inheritance taxes might apply to all beneficiaries, but the closer the relative, the higher the exemption.
Inheritance tax rates vary by state. The top tax rates may be as low as 6% in Iowa and as high as 16% in Kentucky and New Jersey.
Capital gains tax
The capital gains tax is a federal tax imposed on the sale of assets (some states also have a capital gains tax). You may be subject to capital gains taxes when you sell an asset — anything from a share of stock to your home — for more than you purchased it.
Capital gains taxes apply to inheritances when the beneficiary decides to sell any of the assets they’ve inherited. For example, if a grandparent passes away and leaves you $100,000 worth of stock and you later sell it for $150,000, you’ll be subject to capital gains tax on the $50,000 gain.
Federal capital gains are taxed at either 0%, 15%, or 20%. The rate you’ll pay is based on your taxable income for the year.
The good news is that when you inherit an asset, you generally get to enjoy a stepped-up cost basis. For example, suppose your grandparent initially purchased that $100,000 of stock for just $25,000 many years ago. You don’t pay capital gains taxes based on the $25,000 initial value. Instead, your cost basis in the asset is its value at the time of your grandparent’s death.3
Read more: Ways to avoid or minimize capital gains tax
Income tax
In most cases, an inheritance isn’t subject to income taxes. The assets a loved one passes on in an investment or bank account aren’t considered taxable income, nor is life insurance. However, you could pay income taxes on the assets in pre-tax accounts.
Suppose your loved one has significant assets in a 401(k) plan, a traditional IRA, or even a health savings account (HSA). Contributions to those accounts are made pre-tax, while withdrawals are generally subject to income taxes.
If you inherit assets in a pre-tax account, you can often choose to roll them over into a pre-tax account. However, if you decide to withdraw the money, it will be considered income and will be subject to ordinary income taxes.
Common inherited assets and their tax implications
Many different types of assets can result in tax liability when inherited from a loved one. However, there are a handful of assets that are the most likely culprits.
- Stocks and cash: Inherited cash generally isn’t taxable unless the estate exceeds the applicable estate or inheritance taxes. Stocks also aren’t taxable unless they are subject to estate or inheritance taxes but could result in capital gains taxes when you sell them.
- Retirement accounts: The money in inherited pre-tax retirement accounts is considered taxable income if you withdraw it from the account or from a rollover account. Additionally, money in Roth accounts won’t be subject to income taxes upon withdrawal.
- Real estate: A family home or another piece of real estate can be a considerable asset. If you sell the home after you inherit it, you could pay capital gains taxes. However, inherited real estate enjoys the stepped-up basis we discussed earlier.
- Art and other collectibles: Real estate isn’t the only valuable physical asset someone might inherit. If you inherit art or other valuable collectibles, it will be subject to similar capital gains rules as any real estate you inherit.
- Life insurance policies: Life insurance policies generally aren’t subject to the same tax rules as other inherited assets. Life insurance isn’t included in the estate for estate tax purposes, nor is it considered taxable income. The only tax liability you might be subject to is if you choose to receive the proceeds in installment payments.
Ways to protect your inheritance from taxes
Though taxes most often only apply to large inheritances, they can still place a burden on families already going through a difficult time. If you have received an inheritance, expect to receive an inheritance, or are doing your own estate planning and want to reduce the tax liability for your loved ones, there are several steps you can take to save money on taxes.
Transfer assets into a trust
Certain types of trusts can help avoid estate taxes. An irrevocable trust transfers asset ownership from the original owner to the trust beneficiaries. Because those assets don’t legally belong to the person who set up the trust, they aren’t subject to estate or inheritance taxes when that person passes away.
Setting up a trust also has other financial benefits, such as helping the estate avoid probate. Additionally, a trust can help create privacy during the estate settling process.
Read more: Estate planning primer: Trusts and estates
Minimize pre-tax distributions
Inherited pre-tax retirement accounts can create an income tax burden if you withdraw the money. You can reduce your tax burden by avoiding distributions. There are a few alternatives to consider instead:
- Only take distributions from Roth accounts, which aren’t subject to income taxes
- Use a Roth conversion to move pre-tax dollars into a Roth account, which creates an upfront tax burden, but will allow for tax-free withdrawals later on
Implement a gifting strategy
There are a couple of ways that strategic gifting can help reduce your tax liability, either on your own estate or on assets you inherit from someone else.
First, one way to avoid the estate tax is to make small, non-taxable gifts to your beneficiaries during your lifetime. The gift and estate tax share an exemption — it’s known as the unified credit — but the IRS allows you to gift up to $18,000 per person in 2024 without filing a gift tax return or impacting your total gift and estate tax exclusion.3
Suppose you have a large estate and plan to divide it among your many children and grandchildren. You could give each of those loved ones up to the gift tax exclusion each year. It would reduce your estate for estate tax purposes while helping you avoid gift taxes.
Read more: Gift tax: What is it and how does it work?
Another way to implement strategic gifting is to give money to charitable organizations. Charitable gifts are tax-deductible. Additionally, they aren’t considered taxable gifts for gift tax purposes. You can use charitable gifting to either reduce your estate tax liability or offset your tax liability for an inheritance you’ve received.
State-specific planning
We’ve talked about the federal estate tax and capital gains taxes, as well as the handful of states that impose estate and inheritance taxes. However, each state has its own laws and taxes in place. It’s important to understand potential tax liabilities on inheritances based on your state. Additionally, working with an estate planning professional in your state can help you utilize relevant strategies to minimize any state-specific taxes.
Seeking professional guidance
Most people won’t have to worry about estate taxes and inheritance taxes. However, certain types of taxes on inheritances, including capital gains and income taxes, are far more prevalent.
Whether you have a large estate that may be subject to estate taxes or a small estate that you want to minimize taxes on, it may be worth hiring a tax professional.
An estate planning attorney can help you take steps upfront to set up your estate in a way that helps to minimize taxes for your beneficiaries. Additionally, if you’ve received an inheritance, an estate planning attorney or financial professional may be able to help you reduce your tax burden.
The bottom line
Receiving a large inheritance can be an emotionally fraught time. While there may be great financial benefits, it also usually means you’ve lost someone close to you. And having to navigate and pay taxes on your inheritance just adds another burden.
Whether you’re planning your own estate or receiving an inheritance from someone else, it’s important to understand the various taxes you might be subject to. Do your research to learn about the different ways you can manage your tax liability. Finally, consider hiring a professional who can guide you through the process and help you save money on taxes.
