Estate taxes can take a bite out of your inheritance income. While many beneficiaries can avoid the brunt of inheritance taxes, they will have to pay income tax on estate distributions. Let’s break down when and how much beneficiaries have to pay on estate distributions.
A financial advisor can help you create an estate plan to mitigate your family’s tax liability on their inheritance.
Inheritance Taxes
As the beneficiary of an estate, the first tax hurdle to clear is the estate tax. The good news is that the vast majority of estates will not trigger the federal estate tax. As of 2022, an estate can be worth up to $12.06 million before a federal estate tax is required. S0 with this high of a threshold, most Americans won’t have to worry about an inheritance tax.
But if you reside in certain states, you might be required to pay estate taxes on a state level. In 2022, 12 states and the District of Columbia levy an estate tax. These include:
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Connecticut
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Hawaii
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Illinois
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Maine
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Maryland
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Massachusetts
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Minnesota
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New York
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Oregon
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Rhode Island
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Vermont
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Washington
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Washington, D.C.
Do Beneficiaries Pay Taxes on Estate Distributions?
Estates are taxed as separate entities by the IRS so income taxes must be filed for the estate. In some cases, the estate will owe taxes on any income earned through its assets.
If the estate pays the appropriate amount in taxes, the beneficiary shouldn’t be responsible for taxes. However, if the estate distributes taxable income to its beneficiaries before paying taxes, then the beneficiary will be responsible for taxes on that income.
IRA exceptions. As with most tax rules, there are exceptions to take into consideration. Specifically, things get complicated when an Individual Retirement Account (IRA) is involved.
If you inherit an IRA, assuming that the total value of the estate is less than $12.06 million you won’t owe income tax on the funds you inherit in 2022. However, the IRS will require that you take required minimum distributions.
With an IRA, you will typically have to take an RMD when you reach age 72 (or 70.5 if you were born before July 1, 1949). But for an inherited IRA, the IRS says:
“The 10-year rule requires the IRA beneficiaries who are not taking life expectancy payments to withdraw the entire balance of the IRA by December 31 of the year containing the 10th anniversary of the owner’s death.”
These distributions will be added to your taxable income on the tax year when the RMD is made.
For those who inherit a Roth IRA, you will eventually need to withdraw the money from the account. However, you won’t have to pay income tax on the distributed funds.
Short History of Estate Taxes
As we already stated, taxes must be paid on the distributions received from an estate’s assets, either by the estate itself or the beneficiary.
In the past, the estate tax was not only applied to estate distributions, but also family assets that included property. Critics called this a “death tax.” And in 2010, a federal estate tax exemption of up to $5 million was put in place. Since then, Congress has passed legislation to raise the exemption to $12.06 million in 2022.
Additional tax changes could also end other exemptions that benefit wealthy taxpayers. In 2022, President Biden has called for ending a longstanding exemption for inherited investments.
This exemption is known as a step-up basis and it essentially resets an asset’s original cost basis to its value on the date of inheritance. This loophole allows high-income investors to avoid paying capital gains tax on assets that have grown over decades.
Bottom Line
Most Americans will not inherit a large enough estate to trigger the estate tax. But they will have to pay income tax on estate distributions.
Estate Tax Tips
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A financial advisor will help you optimize a financial plan to mitigate your tax liability. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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While an inheritance usually isn’t considered income, certain types of inherited assets have tax implications. Here’s a breakdown of inheritance taxes and exemptions.
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