Hey everyone! It’s Finance Fridays, and I’m going to talk about something that most people probably don’t know about (I didn’t). I’m going to do a short post today about Inheritance Tax.

Stock Photo from: Pixabay

What is inheritance tax?

Well, it’s kind of there in the name isn’t it? It’s a tax that is triggered when you inherit something from someone who is recently deceased.

However, that is where the simplicity ends.

Everyone hates talking about death and taxes… which is why I am talking about both today.

What do I need to know?

Ok, first things first. When people talk about inheritance taxes, they are talking about state inheritance taxes. There is no federal inheritance tax.

However, there is a federal estate tax. There are also state estate taxes as well. However, that is a post for another time.

Ok, do all states impose an inheritance tax?

No, actually, only 6 of them do. They are (in alphabetical order):

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Sensei’s note: Indiana was also on this list, but it was repealed in 2013.

Spoilers: New Jersey and Maryland have state inheritance and state estate taxes.

How much will I have to pay?

This will vary according to the state above. However, one constant across all states is that surviving spouses are exempt in all six states.

For a general estimate, in above states, you will pay between 0-16%. Not exactly helpful to estimate how much tax you’ll need to pay huh?

Let’s do an example:

Your parents pass away and leave their property to you and your brother, worth ~ $500,000. Your parents lived in New Jersey.

New Jersey divides inheritors into different categories:

[Click to Enlarge]

from NJ Tax Division (5/4/17)

Since you and your brother are the child of the decedent, then neither of you have to pay inheritance tax on the property.

Additionally, because the estate is worth less than $675,000, you won’t have to pay state estate tax either (for New Jersey).

Sensei’s note: New Jersey will increase the state estate tax exemption to $2 million for 2017, and it will be gone in 2018. (which is good)

Let’s look at another scenario:

Mr. Smith passes away and did not have any children, step children, or any adopted children. He was also never married and never had a civil union partner or domestic partner. His parents and grandparents passed away before him.

So no one in Class A is available. The next closest of kin is his younger brother (sibling), who is Class C.

So according the NJ Tax Division (5/4/17):

[Click to Enlarge]

So his younger brother would pay:

0% on the first $25,000
11% on the next 1,075,000

So basically, he’ll pay 11% on $475,000 of the $500,000 he inherited which is $52,250.

Let’s do one more example:

In general, the farther you are in the bloodline from the living relative, the higher the chance you’ll have to pay estate tax.

So if Mr. Smith has no next of kin -at all- and it went to someone in Class D, then that person would pay:

15% of $500,000 inherited or $75,000.

Are the other states pretty similar?

Yea, pretty much. However, it’s worth stating here that while Pennsylvania and Nebraska do exempt spouses from inheritance tax, they do not entirely exempt descendants.

Nebraska exempts the first $40,000 for immediate relatives, then the remainder at 1%. (Remote relatives at 13%)

Pennsylvania exempts the first $3,500 for descendants, then the remainder is taxed at 4.5%. (Siblings at 12%)

What if my inheritance comes in the form of a 401k/403b/457/etc?

If it comes in the form of a pre-tax retirement account, then you, as the inheritor, will need to report it as taxable income.

Example:

Your father passes away and leaves you $100,000 in a 401k (not a Roth 401k).

You currently make $100,000/year. If you are forced to take the inheritance as a lump sum distribution for that tax year, then your reportable taxable income will be $200,000. If you were married filing jointly, this would change your highest tax bracket from 25% to 28%. More specifically, every dollar over $153,100 would be taxed at 28%.

However, some 401k/403b/457s may allow you to distribute the inherited 401k over 5 years. This would make your tax burden decrease as your yearly taxable income will be $120,000 ($100,000 + $20,000 from 401k) for 5 years. This stretches out your tax burden and would keep you in your 25% tax bracket.

There are slightly different rules for spousal heirs versus non-spousal heirs. In general, for a spousal heir, you must begin taking required minimum distributions (RMD) beginning at age 70 ½.

This becomes a little more complex based on if you roll-over the inherited 401k/403b/457 into your own IRA. This allows you to stretch out the tax burden over a longer period of time than 5 years, as long as you take out the required minimum distributions (RMD) yearly.

Note: If it is a Roth 401k/403b, which is a post-tax retirement account, then it does not need to be reported as income. The tax has already been paid.

Anything else?

Yea, in New Jersey, the executor must file a tax return (form IT-R) and any tax must be paid within 8 months of the date of death.

This will vary slightly by state. I am just using New Jersey as my example because it currently has the lowest state estate tax exemption, as well as having an inheritance tax and the federal estate tax. With the current taxes, if you die in New Jersey you could leave a significant tax burden to your inheritors, unless you plan ahead. However, as I stated above, since New Jersey is phasing out its state estate tax in 2019, that may make it a little better.

Why does this matter?

It really doesn’t matter all that much for someone early in their career. However, these taxes could change yearly, and small changes can add up. Who knows where they will be in 20-30 years from now. I’m not telling you all to run out and get some estate planning done or put your house into a trust. However, it’s just another thing to keep in mind.

I will revisit what I think about trusts in the near future as well, but the long and short of it is many (or even most) of us will never have enough assets to leave to our kin to hit the mark.

Like I said before, the current federal estate tax exemption is $5.49 million per individual in 2017, up from $5.45 million in 2016. Now, that may seem like a lot of money, and granted many of us will never have acquired that much to ever run into this issue.

However, if you consider 30 years of compound interest as well as 30 years of increases in housing price, and then maybe it’s not an impossibility.

Disclaimer:

Just want to remind you that I am not a lawyer nor am a tax professional. As of 5/4/17 I did my best to research this information for informational/educational/entertainment purposes. This is not legal or tax advice. Full Disclaimer at the bottom of my About page

TL;DR

Inheritance tax is a state tax. There is no federal inheritance tax.

Spouses are exempt in all 6 states that currently have an inheritance tax.

Other states classify descendants and tax differently based on this.

In general, the farther away from the decedent you are, the higher inheritance tax you will likely pay.

This ranges between 0-16%. This isn’t horrible, however, if you include state estate taxes and federal estate taxes on a larger estate, it can add up quickly.

Estate taxes can change yearly, and staying informed on the current estate tax situation is probably a good idea. While most doctors probably won’t trigger an estate tax right now, depending on how taxes change, and the wonders of compound interest, it may become more common in our lifetime.

I’ll talk about estate taxes and touch on trusts a bit next week.

-Sensei

Agree? Disagree? Questions, Comments and Suggestions are welcome.

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