Will I Have to Pay Taxes on My Inheritance?

by Eric M. Schorr

One of the most common questions we get is whether you will have to pay taxes on your inheritance. Before you can answer this question, you need to understand that the term “taxes” actually encompasses four (or more) different types of taxes: inheritance taxes, estate taxes, income taxes and capital gains taxes. Whether or not your inheritance will be subject to one or more of these taxes will depend on many factors, so let’s address these one at a time:

LOUISIANA INHERITANCE TAX

Inheritance tax is a tax that is imposed on a person as the result of receiving money or other assets from the estate of someone who is deceased. The good news is that, while some other states still tax inheritances, Louisiana abolished its state inheritance tax in 2004. Consequently, if the decedent lived in Louisiana at the time of his death, you won’t owe inheritance tax.

FEDERAL AND STATE INCOME TAXES

Generally, an inheritance is not considered earned income, so you will not have to report your inheritance on your state or federal income tax return, and it will not be subject to Federal or State income tax. There are, however, some exceptions: The two most common exceptions are retirement plans and annuities. These tax-favored investments come to the beneficiary with built-in tax consequences. For example, if you inherit a traditional IRA or 401(k) that was funded with pre-tax dollars, you will have to include all distributions as ordinary income during the year in which you take the distributions, and those distributions will be taxed as such. For annuities, you will pay tax only on distributions above the cost that the original annuity owner paid.

CAPITAL GAINS TAX

If you inherit non-cash assets and then later sell those assets, you may incur capital gains taxes based on the difference between the inherited value of the property versus the sales price that you receive. Currently, assets you inherit receive a “stepped-up” basis to the value on the date of the decedent’s death. For example, if a person purchases a home for $50,000 and you inherit the home which had increased in value to $100,000 on the decedent’s date of death, your basis in the home is “stepped up” to $100,000. If you turn around and sell the house for $150,000 a few years later, then you will owe capital gains taxes on the $50,000 increase in value.

FEDERAL ESTATE TAXES

Federal Estate Tax is a tax on your right to transfer property at your death. Unlike Inheritance tax which is paid by the recipient of assets, Federal Estate Tax is paid by your estate. Fortunately, the Federal Government grants an exemption to estates valued below a certain level (i.e., the Exemption Equivalent Amount). For 2017, the Federal Estate Tax Exemption is $5,490,000, but it changes from year to year based on the Government’s inflation index. It is also worth noting that any transfers between spouses, regardless of value, are not subject to Estate Tax.

THE BOTTOM LINE ON INHERITANCE TAX

There are many misconceptions about taxes and inheritances, and the application and calculation of taxes is far more complicated than can be explained in the limited space provided. You should always consult with a qualified estate planning attorney or accountant and have them explain what taxes apply to your particular situation.

This article was originally published in Senior Living Magazine

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