When someone leaves you money in a will, how much can you have before you pay inheritance tax? On the other hand, if you want to leave money to your loved one, how much money can you leave before inheritance tax takes effect? Some may consider these questions as inappropriate, but when you want to pass on your legacy or expect to receive gifts from your loved ones, you need to have answers to them.
How Inheritance Taxes Work
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. Understanding common inheritance situations, such as gifts to grandchildren or income tax on gifts from grandparents, can help you prepare a solid financial strategy when the time comes to report your taxes.
Determining the Appropriate 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. A grandchildren inheritance tax is one of many common inheritance taxation scenarios.
Not all states have inheritance tax requirements. As of 2021, just six states impose an inheritance tax – Iowa, Kentucky, Nebraska, New Jersey, Maryland and Pennsylvania – and spouses are exempt in all of them.
In 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. However, in situations where a trust fund for grandchildren or other relatives has been established, other taxation regulations may apply.
Local Taxation Rates
Each state sets their 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.
Most inheritance tax rates go up to 18 percent, but the rates charged may depend on the size of the inheritance and the relationship between the recipient and the giver. Siblings of the deceased may pay less on the inherited amount, compared to the more distant relatives. For example, in New Jersey, children don’t pay anything, but siblings will pay anywhere from 11 to 16 percent for an inheritance valued over $25,000.
If you inherit property, there is a potential that you will have to sell the property in order to pay the tax. So, 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.
Obtaining Your Tax Benefits
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 $15,000 or less annually as of 2021 have no tax consequences to either the giver or the recipient. That amount will rise to $16,000 in 2022.
Gifting prior to death is often an effective way to avoid inheritance tax issues. For example, gifts to grandchildren prior to death can help remove the threat of inheritance tax. If the estate is large, estate planning should be done with the guidance of an estate attorney and a professional accountant.
Reporting Your Taxes
Form 1040 is commonly used to report any gains from an inheritance, including interest, dividends and other forms of income. Anyone receiving an inheritance should consult this form (and a CPA, if needed) in order to ensure that they do not run afoul of IRS taxation guidelines.
Read More: Form 1040: What You Need to Know
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.