Anticipating or receiving an inheritance can be a difficult time as the passing of a loved one is a somber affair. Despite this, it is still wise to educate yourself on how your inheritance will affect your taxes.
You may be wondering whether you must pay federal taxes on an inheritance, and the short answer to that is no. However, there are a few IRS tax-related scenarios, like when you sell inherited real estate, you should understand so there are no surprises.
What’s the Difference Between Inheritance Tax and Estate Tax?
Inheritance tax and estate tax are often thought of as the same, likely because they are both considered death-related taxes. However, the two are actually quite different.
Inheritance tax would apply to a beneficiary but there is currently no federal tax for inheritance and only a handful of states impose this tax.
This means your inheritance isn’t generally required to be reported as income for federal taxes. Estate taxes, on the other hand, are charged by the IRS and are based on the value of assets being transferred to heirs after death.
Estate tax only applies if the combined value of property and assets within the estate exceeds the federal exemption amount of $12.92 million in 2023 or $13.61 million in 2024.
If estate taxes are due, these are taken from the value of the estate before assets are given to heirs.
Do I Have To Report Inheritance On My Federal Taxes?
As mentioned above, you don’t need to report inheritance as income on your federal tax return.
Note that some states, like Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, charge inheritance tax even though the IRS doesn’t.
Are There Any Situations When the IRS Can Tax Inheritance?
Although federal taxes for “inheritance” are limited to a one-time estate tax that covers the total value of all assets being distributed, federal taxes may apply for specific types of items inherited.
If You Inherited Investments or Property, Do You Pay Capital Gains Taxes When You Sell?
If you receive an asset that appreciates in value while in your possession, you could be subject to tax on capital gains if you sell that asset later. You should consider this when the inheritance includes real estate or investments.
Can You Rollover Inherited IRA and How Does That Affect Taxes?
Another possible tax liability comes into play if you inherit an IRA. If inherited from your spouse, you can either name yourself as the owner of the account or simply roll it over into your existing IRA.
If you inherit an IRA from someone other than your spouse, your options are much more limited. You have the option of cashing the IRA out in a lump sum distribution which will avoid the early withdrawal penalty, but will subject the recipient to federal income taxes on the amount received.
You can also open an inherited IRA which keeps the account in the deceased person’s name while you are named beneficiary. You will not be able to contribute to it and this option only lasts for 10 years before funds are required to be dispersed from a traditional IRA, or 5 years for a Roth IRA.
If You Received a “Gift” Instead of Inheritance, How Much Will You Owe for IRS Gift Tax?
It is possible for the person leaving assets behind to reduce federal estate taxes after they pass by giving their heirs gifts in advance.
To not have to pay the IRS gift tax, the amount gifted each year must fall below the annual exclusion amount, which is $17,000 for 2023 and $18,000 for 2024.
This amount applies to each individual gift, however, so the exclusion amount could be given to multiple recipients, over several years, without ever paying gift taxes.
Gifts to spouses are exempt from IRS gift tax, as well as any gifts used to pay for medical care or tuition that fall below the exclusion amounts set for these scenarios. If the gifts are given by both spouses, the exclusion amounts double.
Setting up an irrevocable trust is another way to avoid or reduce estate tax assessment.
What If I Owe Estate, Gift, or Capital Gains Taxes Related to Inheritance and Can’t Pay?
If you find yourself with an outstanding tax liability that is related to an inheritance, and you can’t pay the IRS, schedule a free call to see how we can help..
The IRS will consider your complete financial situation – income, assets, and expenses – when determining the best tax relief service for you.
IRS tax debt help ranges from monthly payment plans to reducing your tax liability (Offer in Compromise). Pausing collections temporarily could also be an option with a (Currently not Collectible status).
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