Understanding How to Pay Inheritance Tax

Quick answer

• Inheritance tax is a tax on the value of assets you receive from a deceased person’s estate.
• In the U.S., federal inheritance tax (known as the estate tax) is typically paid by the estate, not the beneficiary.
• State inheritance taxes vary significantly; some states have them, others don’t.
• If you receive an inheritance, you might owe income tax on any earnings the inherited assets generate after you receive them.
• Your primary responsibility is to understand if any tax is due and to whom, then ensure it’s paid by the estate or yourself as required.

What to check first (before you file or change withholding)

Filing Status

Your filing status for income tax purposes (e.g., Single, Married Filing Jointly) is generally not directly affected by receiving an inheritance, but it’s a fundamental aspect of your personal tax situation. Knowing your correct status ensures you file your own income tax returns accurately.

Income Sources

An inheritance itself is usually not considered taxable income to the beneficiary at the federal level. However, any income generated by the inherited assets after you receive them, such as dividends from stocks or interest from bonds, will be taxable income to you in the year it’s earned. Keep track of all your income sources, including inherited assets that are now generating income.

Withholding or Estimated Payments

If your inherited assets start generating significant income, you may need to adjust your tax withholding or make estimated tax payments throughout the year to avoid penalties. The IRS requires you to pay tax as you earn or receive income. If your regular paycheck withholding isn’t enough to cover your total tax liability, including new income from an inheritance, you’ll need to make up the difference.

Deductions and Credits

While an inheritance itself doesn’t usually qualify for deductions or credits, understanding your overall tax picture is crucial. Certain expenses related to managing or selling inherited assets might be deductible in specific circumstances, but this is complex. Focus on ensuring your personal tax return is accurate, taking all eligible deductions and credits you’re entitled to, separate from the inheritance itself.

Deadlines and Extensions (General)

The deadlines for filing your own income tax return are generally April 15th (or the next business day if it falls on a weekend or holiday) for federal taxes. If you owe taxes, payment is also due by this date. If you need more time to file, you can request an extension, but this typically does not extend the time to pay any taxes owed. For estate tax, the deadline is usually nine months after the date of death, though extensions are possible.

Step-by-step (simple workflow)

1. Determine if an inheritance tax is applicable.

• What to do: Research federal and state laws regarding inheritance and estate taxes. Federal estate tax applies only to very large estates. State inheritance taxes vary greatly; some states have them, some have estate taxes, and many have neither.
• What “good” looks like: You have a clear understanding of whether federal or state inheritance/estate taxes are owed by the estate or by you.
• Common mistake and how to avoid it: Assuming all inheritances are tax-free. Avoid this by checking the specific tax laws of the deceased’s state and federal regulations.

2. Identify the executor or administrator of the estate.

• What to do: This is the person legally responsible for managing the estate’s assets and debts, including paying any taxes.
• What “good” looks like: You know who the executor is and can communicate with them.
• Common mistake and how to avoid it: Trying to handle tax matters yourself without coordinating with the executor. Avoid this by working through the designated estate representative.

3. Understand what assets you are inheriting.

• What to do: Get a clear list of all assets (cash, stocks, real estate, personal property, etc.) you are set to receive.
• What “good” looks like: You have a detailed inventory of your inheritance.
• Common mistake and how to avoid it: Not getting a full accounting of assets, leading to potential future disputes or missed tax implications. Avoid this by requesting a formal accounting from the executor.

4. Determine the value of the inherited assets.

• What to do: Assets are typically valued at their fair market value on the date of the decedent’s death or an alternate valuation date. Professional appraisals may be needed for certain assets like real estate or art.
• What “good” looks like: You have documented valuations for all significant inherited assets.
• Common mistake and how to avoid it: Using an incorrect valuation date or method. Avoid this by following IRS guidelines and using qualified appraisers when necessary.

5. Confirm if the estate owes federal estate tax.

• What to do: The executor will determine if the total value of the estate exceeds the federal estate tax exemption amount. If it does, the estate will need to file Form 706.
• What “good” looks like: The executor has assessed the estate’s value against the exemption and filed necessary forms if applicable.
• Common mistake and how to avoid it: The executor failing to file Form 706 for a taxable estate. Avoid this by ensuring the executor is aware of the filing requirements and deadlines.

6. Check for state inheritance or estate taxes.

• What to do: The executor or beneficiaries must check the laws of the state where the deceased resided and potentially where assets are located.
• What “good” looks like: You know if state taxes are owed and by whom (estate or beneficiary).
• Common mistake and how to avoid it: Overlooking state-specific taxes, especially if the deceased lived in a state with inheritance tax. Avoid this by researching the specific state’s tax laws.

7. Receive the inheritance.

• What to do: Once all estate taxes and debts are settled, the executor will distribute the remaining assets to the beneficiaries.
• What “good” looks like: You have received your inheritance.
• Common mistake and how to avoid it: Beneficiaries attempting to take possession of assets before the estate is settled. Avoid this by waiting for the executor’s formal distribution.

8. Report any income generated by inherited assets on your personal tax return.

• What to do: If your inherited assets (like stocks or rental properties) generate income in the year you receive them or subsequent years, you must report this income on your annual federal and state income tax returns.
• What “good” looks like: All income from inherited assets is correctly reported on your tax return.
• Common mistake and how to avoid it: Forgetting to report income generated by inherited assets. Avoid this by keeping good records of any earnings and consulting a tax professional if unsure.

9. Consider adjusting your own tax withholding or estimated payments.

• What to do: If the income from your inheritance is substantial, you may need to increase your tax withholding from your job or make quarterly estimated tax payments to avoid underpayment penalties.
• What “good” looks like: Your tax payments throughout the year align with your expected total tax liability.
• Common mistake and how to avoid it: Not adjusting tax payments, leading to a large tax bill and potential penalties. Avoid this by reviewing your tax situation and making adjustments as needed.

Common mistakes (and what happens if you ignore them)

| Mistake | What it causes | Fix