When someone passes away, loved ones are often left wondering about both emotional and financial matters. After spending time grieving their loss, many beneficiaries begin thinking about what happens next. This can include practical questions about probate, what to do with their money, taxes, and more.
A common question is whether inheritance is taxable. Do beneficiaries have to pay taxes on money they inherit from a loved one? The short answer is that it depends.
While most inheritance isn’t taxed directly, there are circumstances in which various taxes can come into play. Beneficiaries may be responsible for federal taxes on an inheritance in certain situations. In some cases, the estate may be responsible for taxes before assets are distributed.
It’s important to understand the various ways taxes can apply so that you aren’t caught off guard later.
Is My Inheritance Taxable? Who Pays Tax?
It’s not uncommon to wonder if your inheritance will be taxable. But just because you inherit money from a loved one doesn’t mean taxes will automatically be taken from it.
In many situations, your inheritance will not be considered taxable income by the IRS.
Instead, inheritance tax issues may arise depending on what you do with the money later or if the estate itself was large enough to qualify.
Many people misunderstand how taxes can apply to inherited assets. For example, just because an inheritance is not taxable doesn’t mean your loved one didn’t pay taxes on it.
You should also be aware that estate taxes, inheritance taxes, capital gains taxes, and income taxes can all still affect an estate or its beneficiaries.
Estate Tax vs. Inheritance Tax
Many people use the terms estate tax and inheritance tax interchangeably, but they are actually two distinct entities.
An estate tax is a tax paid by the estate based on its value. Inheritance tax is paid by the beneficiary who receives the asset.
The key difference is that estate taxes are paid by the estate before assets are distributed. Beneficiaries then receive whatever remains after taxes and other expenses have been paid.
Inheritance tax, on the other hand, is paid directly by beneficiaries as a result of inheriting property.
Florida does not currently have a state inheritance tax. Additionally, Florida is not subject to any state estate tax separate from any federal estate tax that might apply.
For many families, this means that their inherited assets will pass without additional state-level inheritance tax.
Federal taxes may still be owed in some cases, especially if a large estate is left behind.
Do I Owe Taxes on Inherited Money?
As mentioned, beneficiaries do not typically have to worry about federal taxes on an inheritance. Inheritance is not considered taxable income for federal tax purposes.
If you inherit money from a loved one’s bank account, retirement account, or other asset, you will usually not owe taxes on it.
This even applies if you inherit:
- Cash
- Real estate
- An investment account
- Personal property
While many beneficiaries do not owe taxes on their inheritance, that doesn’t mean taxes never come into play. You should know that certain actions may trigger tax events related to an inheritance down the road.
For instance, while you may not owe taxes on an inheritance itself, you can still be taxed if you sell inherited property.
If you sell the property and make a profit, you may be required to pay capital gains taxes on the money. Whether you owe taxes on an inheritance eventually can depend on what you do with it.
Inherited Assets That May Be Taxable
Just because you inherit something from a loved one doesn’t mean you’ll automatically owe taxes on it. However, if you do decide to sell the inherited asset, you may be required to pay taxes.
As mentioned above, one of the most common situations in which beneficiaries are responsible for taxes is the sale of inherited property.
If you sell real estate or investments for more than what they’re worth, you could be taxed on the profits.
However, many inherited assets come with what’s called a “stepped-up basis”. The step-up in basis means the original purchase value is adjusted to reflect the current fair market value.
Let’s say your father left you his stock portfolio when he passed away. He originally purchased the stocks for $10,000, but they were worth $200,000 when he died.
Because the stocks were inherited, your basis in them is “stepped up” from $10,000 to $200,000. If you immediately sell them for $200,000, you likely won’t owe any capital gains taxes.
If your basis was not stepped up when you inherited the assets, you could be taxed on the full amount of growth.
Inherited retirement accounts can also cause you to owe taxes. Beneficiaries are generally responsible for paying income tax on any withdrawals from retirement accounts such as traditional IRAs.
This is because most retirement accounts are funded with pre-tax dollars that haven’t been taxed yet.
The rules for inheriting retirement accounts have changed in recent years. It’s important to consult with a financial advisor if you inherit an IRA or retirement account.
Who Is Responsible for Paying Federal Estate Taxes?
If estate taxes are owed to the federal government, they are typically paid by the estate before it’s distributed to beneficiaries. Estates that don’t exceed the tax threshold aren’t subject to federal estate taxes.
Federal estate taxes apply to estates valued at millions of dollars. However, there are ways to reduce your estate’s tax burden through various planning techniques.
Estate taxes can have a huge impact on the wealth that’s passed down to your family. If you have a sizable estate, it’s important to work with a financial advisor or estate planning attorney.
Are Life Insurance Benefits Taxable?
Life insurance policies are generally not taxable to beneficiaries. However, there are certain instances in which life insurance proceeds may be taxable.
As with estates, life insurance benefits are typically taxed before being distributed to the beneficiary. If the insured person names their estate as the beneficiary of their life insurance policy, those proceeds will pass through the estate.
In some cases, larger estates may owe federal income tax on life insurance proceeds. For that reason, some high-net-worth individuals opt to create a special life insurance trust.
When held within the estate, life insurance proceeds won’t be taxable to the estate.
Do Taxes Vary by State?
Inheritance laws and taxes vary from state to state. As we mentioned earlier, Florida doesn’t have a state inheritance tax.
However, some states still do. When it comes to inheritance taxes, many states consider:
- The beneficiary’s relationship to the deceased
- Where the deceased lived
- Location of the inherited property
- Type of asset inherited
Spouses are commonly exempt from inheritance tax in states that have them. Taxes may also vary depending on whether the beneficiary is a child or relative.
Do I Need a Will or Estate Plan?
If you want control over who inherits your wealth, you should consider creating a will or estate plan. Many people mistakenly believe that their assets will automatically pass to their spouse if they die without a will.
While this is often true, it’s not guaranteed. Having a will lets you decide who receives your assets.
Additionally, some assets require you to create an estate plan in order to transfer them. That’s why it’s important to work with an estate planning attorney who can advise you on what you need to do.
An experienced attorney can also help identify ways to reduce your estate tax liability and keep more money in your family’s pockets.
Talk to an Estate Planning Lawyer in Florida
Whether you need to create an estate plan or are currently administering a loved one’s estate, you shouldn’t try to go through the process alone. An experienced estate planning attorney can help ensure everything is done correctly and on time.
At Patton Law Group, we offer compassionate estate planning and administration services to families throughout Florida. Contact our office today and let us help you with your estate planning needs.
