How an Inheritance Is Taxed

John Muth is a senior director in Sophisticated Planning Strategies at Northwestern Mutual.

Whether you’re preparing to leave behind a legacy or you think you’ll inherit money (or other assets), it’s only natural to wonder how an inheritance is taxed.

The good news is many people won’t owe any taxes at all on their inheritances. But depending on a variety of factors—including what’s being passed down, how much it’s worth and where you live—you may have an estate tax bill coming your way.

Below, we discuss how estates, inheritances, life insurance and retirement accounts are taxed as part of an inheritance. We also answer other questions and offer advice you might be able to use to lower the transfer tax burden on inherited wealth.¹

How does estate tax work?

The estate tax, as the name suggests, is the transfer tax that is charged when an individual transfers their assets, including property, possessions and financial holdings at their death, to certain people who survive them. This is typically their spouse and other family members. It is also commonly called a “death tax,” though that’s a little misleading.

The federal government has a top estate tax of 40 percent when wealth is passed between generations. The good news is the U.S. currently has a $13.61 million estate and gift tax exemption, which means many estates won’t owe any federal estate tax.

• The tax will only be charged on the portion of the estate’s value that exceeds the $13.61 million exemption in 2024.
• This exemption amount will expire at the end of 2025 and drop to approximately $7 million per person unless Congress takes action to extend the current tax law.
• This estate exemption amount applies to individuals, which means a married couple gets double that amount.

And speaking of couples, spouses’ gifts to each other are completely exempt from estate tax—you could leave $100 million to your spouse without owing any estate tax.

While you must have significant wealth before you will owe federal estate tax, your home state’s tax laws may be a different story. Currently, 12 states and the District of Columbia levy an estate tax—and all of them set their own rates and exemption levels. Oregon, for instance, currently charges an estate tax if an estate is worth more than $1 million, while Massachusetts exempts the first $2 million (as of January 2023). Connecticut offers the highest exemption, matching the federal exemption level.

How does inheritance tax work?

Unlike the estate tax, which taxes the estate of the person who has passed away, an inheritance tax affects the person receiving the money. There is no federal inheritance tax, but several states have one.

The tax rates and exemptions vary a lot between the states. Review the list of how each state taxes estates and inheritances.

Are retirement accounts subject to estate or inheritance taxes?

Keep in mind that what you inherit can have an impact on whether or not you owe taxes on your inheritance. For example, even if you’re exempt from estate or inheritance tax, it’s possible that you’ll owe income taxes on certain inherited retirement accounts.

That’s because qualified retirement accounts like traditional 401(k)s or IRAs have never been taxed. Heirs who are named as beneficiaries of these pre-tax-qualified accounts typically must take distributions (make withdrawals) from them and pay taxes on the distributions.

How much you’re required to withdraw depends on several factors, including what type of qualified account it is, whether you are a surviving spouse or non-spouse beneficiary, how much is in the account and whether the person who passed it on had already started taking distributions.

Again, when it comes to spouses, different rules apply. A spouse can retitle a retirement account if they were listed as the designated beneficiary—basically making it their own, which allows them to take distributions based on their own situation. They could also opt to take distributions based on when the deceased owner would have reached 72 (this will change to 73 over the next year), the age at which a retirement account owner must start taking required minimum distributions (RMDs).

Is life insurance taxed?

If you are the primary beneficiary on somebody’s life insurance policy, you will receive the death benefit upon their passing. The good news is that, in the vast majority of cases, life insurance death proceeds are income tax-free. In most situations, the named beneficiaries usually get the death benefit without paying income taxes or inheritance taxes.

Estate taxes may be different. If the policy owner and insured are the same person, then the death benefit is included in the decedent’s gross estate and may be subject to estate taxes. It depends on whether the death benefit amount exceeds the federal and state estate tax exemption thresholds.

What is inheritance basis step-up?

When investments such as stocks, bonds, mutual funds and real estate are inherited, there’s some good news from an income tax perspective—many inherited investments typically receive what’s known as a step-up in basis.

Here’s how it works. Let’s say you buy investments for $10,000 (which is your basis). If you sold the investment for $19,000, you would owe tax on $9,000 (your capital gains).

But if you pass away and leave the investment to an heir, that person will get a step-up in basis to $19,000—the fair market value of the assets on the date that you passed away. That means they can sell the investment for $19,000 without owing any income tax.

Not all assets get this basis step-up, so it depends on the asset type and how the asset is owned.

How to minimize or avoid inheritance taxes

If you think that your estate may be subject to estate or inheritance taxes, there may be steps you can take to minimize those taxes and ensure that your heirs keep as much as possible. This includes but isn’t limited to:

• Creating an irrevocable trust: Assets held in an irrevocable trust are not part of your estate and are therefore not subject to estate taxes. Consider the different types of trust—such as an irrevocable life insurance trust, special needs trust, spousal lifetime access trust (SLAT), dynasty trust or grantor-retained annuity trust (GRAT)—and the different roles they may play in planning your estate and minimizing transfer taxes.
• Gift your heirs while you’re still alive: If you live in a state that does not impose a gift tax but does impose estate or inheritance taxes, you may want to consider making financial gifts to your heirs while you are still alive. Just be aware of the annual and lifetime exemptions for federal gift taxes.
• Consider the state where you establish your primary residence: Some people even relocate their primary residence from a state that imposes an estate or inheritance tax. They set up their primary residence in another state without those taxes.

While these are the general rules around how an inheritance is taxed, this is a complicated area of tax law. A Northwestern Mutual financial advisor can work with an estate attorney to help you build an estate plan. The plan can be designed to minimize taxes and maximize the inheritance that gets passed on.

Your advisor can also take a broad look at your money and help you identify blind spots and opportunities that might otherwise be overlooked. You can see how to use multiple financial options that work together to help you protect and grow your wealth while minimizing taxes.

1 State and federal tax laws are subject to change. Financial Representatives do not render tax advice. You should consult tax and legal advisors regarding your particular circumstances.

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