Financial life events require personalized financial advice. Receiving an inheritance is often seen as a financial windfall. It can offer you the ability to pursue dreams and passions that you have put on hold, like traveling the world, paying off debt, launching a business, or embarking on a philanthropic journey. However, your inheritance could also come with a hefty tax bill. 

The good news is there are steps you can take to significantly decrease the amount of taxes you owe on the assets you inherit. Employing a few simple strategies can reduce your tax bill and allow you to keep more of your inheritance.

Will My Inheritance Be Taxed?

Maybe. Whether or not your inheritance is taxed depends on a variety of factors, including what state you live in, what type of assets you inherit, and what you choose to do with your inheritance. Your tax bill could be $0, or it could be much higher. 

When it comes to understanding the tax bill associated with your inheritance, there are four tax types to address: state inheritance tax, capital gains tax, income tax, and estate tax. Next, we’ll explore each of these tax types, how they impact your inheritance, and how you can decrease the tax bill. 

Inheritance Tax

Inheritance tax is the tax you pay on the value of the assets you receive from the deceased. Currently, there are only six states that levy this tax: 

• Iowa (tax ends in 2025)

• Kentucky

• Maryland

• Nebraska

• New Jersey

• Pennsylvania

Tax rates in these states range from 0 to 18%, depending on how much you inherit and your relationship to the deceased, i.e., child versus niece/nephew.

How Can I Reduce My Inheritance Tax Bill?

The good news is the closer your relation to the deceased, the lower your state inheritance tax will be. Unfortunately, you can’t control your relationship to the decedent, but you can control how much you inherit through deductions and exemptions like 

• Money paid for funeral/burial

• Property taxes

• Attorney fees

• Debt and unpaid bills for the deceased

• Agricultural property exemption

• Life insurance exemption

By decreasing the amount you inherit, you’ll reduce the tax bill. You could be exempt from taxes entirely if the inheritance value is low enough. For instance, a brother inheriting less than $100,000 would be exempt from paying inheritance tax in Nebraska. 

It’s crucial that you review your state’s inheritance tax laws to see what your tax rate will be and what exemptions and discounts you can utilize to reduce your tax bill.

Capital Gains Tax

Capital gains tax can apply to nearly any inherited asset, including:

• Property

• A house

• Stock

• Bonds

• Art

• Collectibles

• Furniture

• Antiques

• Vehicles

• Jewelry

This federal tax is only charged when you sell an asset and is calculated based on the selling price versus the asset's value when you inherited it. 

For instance, if you inherit a home with a fair market value of $300,000 and sell it two years later for $350,000, you’ll owe capital gains tax on the $50,000 difference. Depending on your income, you could be hit with a tax rate of up to 20%, resulting in a tax bill of $10,000. 

How Can I Reduce My Capital Gains Tax Bill?

There are several ways you can reduce your capital gains tax bill. Here are a few tips. 

• Sell assets immediately - since capital gains is calculated using sold value versus inherited value, selling assets quickly can minimize your capital gains. 

• Hold assets until retirement - since the capital gains tax rate is based on your income, you can decrease your tax bill by waiting to sell when your income is lower. 

• Offset gains with losses - if you have losses from selling stocks or bonds for less than you purchased them, you can apply these losses to offset your gains.

• Donate - if you have an asset that has significantly appreciated since you inherited it, you can donate it to avoid capital gains tax. You’ll also get a nice income tax deduction that you can carry forward for up to 5 years.  

• Live in an inherited home - if the house you inherited was your primary residence for at least two years, you can exclude up to $250,000 from your capital gains. 

• Use a 1031 exchange - by rolling the sell value into the purchase of another property; you can defer capital gains tax.

A financial advisor can help guide you through which tax-saving options best fit your situation and long-term financial goals. 

Income Tax

Thankfully, the IRS generally does not view the assets you inherit as income. That said, you can be taxed on income you receive from your inherited assets, i.e., interest, dividends, and rental income. 

Pre-tax accounts like 401ks and HSAs are another big issue. When and how you take disbursements from these accounts could significantly impact the income tax you owe.  

How Can I Reduce My Income Tax Bill?

Maximizing your deductions and credits each year is the easiest way to reduce your income tax bill. A tax planner or financial advisor can offer guidance and tips on reducing your tax bill, including utilizing charitable contributions, tax-loss harvesting, and maximizing retirement contributions.

When it comes to reducing the bill on inherited retirement accounts, things get more tricky. For spouses, you can keep the account as is or roll it over with no tax charged until you start taking disbursements. 

Everyone else will need to take disbursements immediately as a lump sum, using the IRS 10-year rule, or using lifetime disbursements (limited situations). Ideally, you should avoid the lump sum disbursement option, as it will come with the highest tax bill. 

Disbursements from an inherited Roth IRA will not incur income tax as contributions were initially made with after-tax dollars. 

What About Estate Taxes?

You will not have to pay estate tax on your inheritance. Instead, this tax is charged directly to the deceased’s estate, and the tax bill is paid before you get your inheritance. Unfortunately, as a beneficiary, there is nothing you can do to offset this tax. 

However, if the inheritance you receive puts you over the federal (or your state) estate tax exemption value, you can start taking steps now to reduce the tax bill your heirs will have to pay. 

The Aligned Perspective: Inheritance Taxes

The best way to reduce the tax bill on your inheritance is to be prepared. Ideally, knowing what you’ll be inheriting and how the estate plan is structured is best, but often, an inheritance is unexpected or comes far sooner than you anticipated. 

When this happens, getting expert guidance from a financial advisor can be a life and tax saver. A good financial advisor can help you navigate the complex world of capital gains and tax-saving strategies. They can also help you manage your own estate, guiding you in the steps you can take to protect the inheritance you will one day leave behind.