An inheritance tax is a state tax that some individuals have to pay when they inherit money on the death of another person. Whether you have to pay inheritance taxes depends on which state you live in and what your relationship was with the deceased. Each state that imposes an inheritance tax has its own rate rules.
Inheritance Taxes Versus Estate Taxes
When someone dies, there may be three taxes involved. The first is the final tax return of the deceased. Any untaxed income will be reported on this return. The second is an estate tax. This relates to the value of the assets in the estate and is paid by the trustee of the estate. There are several rules and exemptions that may mean that there are no estate taxes owing. An inheritance tax may be owed by the beneficiary of an estate. For example, if you inherit $20,000 from your great aunt, you may owe taxes on it in the year you inherit it.
Who Has to Pay Inheritance Taxes?
Not all states have inheritance tax requirements. As of 2011, New Hampshire, North Carolina, Louisiana, South Dakota, Connecticut, Kansas, Pennsylvania, Montana, Delaware, Oklahoma, Maryland, Tennessee, Nebraska, Indiana, New Jersey, Michigan, Iowa and Kentucky have no inheritance taxes. In all other states, there may be a tax depending on your relationship to the deceased. In all inheritance tax states, surviving spouses may inherit tax-free. Children and grandchildren often pay a lower rate of tax than more distant relatives. If you were not related to the deceased at all, you may pay a steep inheritance tax.
How Much Tax Will You Have to Pay?
Each state sets their own rates for inheritance taxes. Children and grandchildren always pay the lowest amounts, and there are many exemptions for smaller inheritances that may make them tax free. Siblings of the deceased pay from 5 to 10 percent tax on the inherited amount. More distant relatives and nonrelatives pay from 10 to 20 percent tax. If you inherit property, there is a potential that you will have to sell the property in order to pay the tax. If you know ahead of time that you will be a beneficiary in a will, discuss your situation with a tax professional to plan for the potential tax hit.
Estate Planning Considerations
When planning the transfer of money and assets on death, there are ways to avoid the inheritance tax hit. Gifts may be made to relatives when the person is still alive. Gifts to relatives that are $10,000 or less annually have no tax consequences to either the giver or the recipient. Gifting prior to death is often an effective way to avoid inheritance tax issues. If the estate is large, estate planning should be done with the guidance of an estate attorney and a professional accountant.
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