Inherited Money is Tax-Free for Many

Do You Owe Tax on That Inheritance?

most will not owe inheritance tax

You just learned that Aunt Millie left you $40,000 in cash in her will.

You’re delighted with the news and then comes the question “Do I owe tax on that”?

In most cases, you will not owe federal or state taxes on that inheritance. The IRS typically does not view inheritances as taxable income. However, if you inherit property that generates income (for example, a rental property); you will likely need to pay tax on that income.

Folks may also owe tax on their inheritance if the estate hasn’t paid some taxes. Like individual taxpayers, estates must also file income tax forms. Estates can owe taxes if the estate is earning dividends, for example. Beneficiaries may need to pay taxes if the estate executor failed to pay income tax before distributing the inheritance.

In addition, the SECURE Act, passed by Congress in late 2019, provides a new wrinkle for some non-spouse heirs of a 401(k). Under this new act, non-spouse heirs must take their taxable required minimum distributions (RMDs) more quickly. When you take an RMD, you must count that as taxable income, since the 401(k) holder contributed to the account pre-tax.

In the past, anyone who inherited a 401(k) could stretch out their RMD over their projected lifespan. Now only spouses can stretch out the RMDs. Non-spouse heirs must drain their inherited accounts within 10 years.

If you plan on leaving a 401(k) to your adult children, grandchildren (or other non-spouse heirs), talk to a tax planner about ways to minimize the RMD problem

Inheritance Tax vs. Estate Tax

Some folks use the terms inheritance and estate tax interchangeable. These terms are two different taxes.

The major difference between an inheritance tax and an estate tax is the payer of the tax. For an inheritance tax, the beneficiaries must pay the tax. With an estate tax, the estate pays the tax before it distributes the proceeds to the heirs.

Another key difference is that only some states levy an inheritance tax, while both the federal government and states may collect an estate tax. The federal government will only charge an estate tax on estates valued greater than $11.4 million.

Maryland Inheritance Taxes

Only six states impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

If you live in Maryland, you may owe an inheritance tax if you are unrelated to the decedent. In Maryland spouses, children, grandchildren or other lineal descendants, stepparents, stepchildren, and siblings, as well as corporations with certain relatives as stockholders, pay no tax.

Also in Maryland, domestic partners who inherit a joint primary residence are exempt from paying inheritance tax. All other individuals must pay 10%

Of note, Maryland is the only state that collects both estate and inheritance taxes.

The District of Columbia does charge an estate tax if the total gross estate exceeds $1,000,000. D.C. will also charge an estate tax to non-residents if the estate includes real estate or other tangible property located within the city and the gross estate exceeds $1,000,000.

Bottom Line

If you inherit money or property, you can get a real boost to your finances. Furthermore, since just a few states tax inheritances, you are likely to get the windfall tax-free.

If you have questions about how your inheritance affects your taxes, please contact us.

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