Is Inheritance Amount Received Income for Tax Purposes?
Although the federal government imposes no inheritance tax, just estate taxes, eight states do collect inheritance taxes (at the end of 2010). With the reintroduction of the federal estate tax in 2011 after a one-year hiatus, some states will be re-thinking their own estate and inheritance tax laws, if they have any. In a nutshell, an estate is taxed, with a $5 million exemption ($10 million for married couples) by the federal government at a 2011 rate of 35 percent. After states with estate taxes take their piece of the pie, inheritance-tax states then impose taxes on what's left for inheritance recipients.
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Inheritance Tax States
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States that levy inheritance taxes include Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. New Jersey and Maryland collect both state estate taxes and inheritance taxes. Maryland, for example, allows a $1 million estate tax exemption, after which the estate is taxed at 16 percent. Then a 10 percent inheritance tax is imposed on property received by all but immediate-family heirs.
Are You Exempt?
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Whether or not you owe inheritance taxes is based first, of course, on where you live. If you reside in one of the eight inheritance-tax states, you may owe taxes based on the amount of your inheritance and your relationship to the deceased. Each state employs its own criteria. Iowa, for instance, exempts spouses, parents, grandparents, great-grandparents, children, step-children, adopted children and other descendants that are lineally related. All other recipients are taxed on the entirety of the inheritance and at varying rates, depending on their relationship (or non-relationship) to the deceased.
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What You Owe
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If you're not exempt from inheritance taxes because you're not a close relative (or a charity or trust in some states), then you need to figure out your tax liability. Kentucky, like other tax-inheritance states, has developed a graduated scale whereby relatives and others are classified (A, B and C) and pay taxes accordingly. If you're a cousin of the deceased, for example, you would be classified in Kentucky as a Class B heir and be subject (after a $1,000 exemption) to rates beginning at 4 percent and increasing to 16 percent. Kentucky also imposes lump-sum penalties in addition to taxes, meaning that an heir receiving a sum between $200,000 and $500,000 would pay a lump-sum payment of nearly $71,000 before being taxed 16 percent on any amount over $200,000.
Non-Inheritance Considerations
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Although not strictly inheritance taxes, there are other taxes involved when you inherit property, no matter where you live. That's because the federal government doesn't consider certain monies received through inheritance "inheritance" at all but, rather, simply income. Capital gains that you may realize from the sale of an inherited house, for instance, are taxable by the IRS; not as an inheritance tax, but as income that you must report on your tax return. The same holds true of retirement plans such as 401k and pension plans that pay benefits upon the estate owner's death. 401k plans and IRAs, in most cases, are treated the same as if the deceased were still alive. If you withdraw the money, that money is treated as income and is treated as 100 percent taxable income (although early withdrawal penalties are normally waived).
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