“How much tax do I have to pay on my inheritance?” the client asked. The lawyer said, “It depends on what you inherited.”
When a person, called the decedent, dies, all of his assets make up his estate. What assets comprise the estate are very important for purposes of determining what, if any, tax the beneficiaries of the estate will have to pay. Another important factor is the relationship of the beneficiary to the decedent. Here are the taxes you will have to consider as a beneficiary of an estate.
As a separate legal entity, the decedent’s estate may have to pay New Jersey inheritance tax or federal estate tax, or both of these taxes. An estate is a legal entity. An estate has its own federal tax identification number, similar to a person’s Social Security number. The estate pays taxes—two of which may be inheritance and estate tax—using that federal tax identification number, commonly known as an EIN.
Most estates would never have to pay federal estate tax because the credit equivalent that all estates receive against the federal estate is currently $11,580,000. This means that an estate would have to be worth more than $11,580,000 before it would have to file a federal estate tax return. Since most estates are worth far less than $11,580,000, most estates do not have to pay federal estate tax.
In New Jersey, an estate may have to pay inheritance tax depending on the relationship of the beneficiaries of the estate to the decedent. If the beneficiaries of the estate were the grandparents, parents, spouse, children, or grandchildren of the decedent, then no New Jersey inheritance tax would be owed. If the beneficiaries of the estate were the siblings, in-laws, more distant blood relatives, or unrelated by blood to the decedent, then the estate will have to file and to pay inheritance tax.
If an estate or inheritance tax is owed, the estate typically pays this tax, not the beneficiaries. When the executor distributes assets from the estate to the beneficiaries, the executor should have already filed the estate or inheritance tax return and paid the tax, so the beneficiary receives his inheritance free of estate or inheritance tax. Of course, whether the executor filed and paid the tax is not always a guarantee. Mistakes are often made in the administration of estates.
The estate may have to file and pay state and federal income tax. The administration of an estate should take, at least, nine months for reasons that are outside the scope of this article. Many estates take a year or more to administer. (Many executors come to me believing that the administration of an estate should be a dash to the finish when, in reality, the administration of an estate is more akin to a marathon—a slow, carefully-considered process.)
During the administration of the estate, the assets of the estate (bank accounts, stocks, bonds, mutual funds, etc.) continue to earn interest and dividends. Someone or something must pay income tax on that income and if the income were earned during the administration of the estate, that something is probably the estate itself, filing the income tax return under the estate’s EIN.
Once the beneficiary receives the inheritance, many inheritances are free of further tax, assuming that the estate paid the estate, inheritance, and income tax that it owed. The one big exception to this statement is when a person is a beneficiary of a qualified account, such as an IRA, 401(k), or qualified annuity. Because the decedent never paid income tax on his IRA, someone has to pay the income tax on this account, and that someone is the beneficiary of the IRA.
As the beneficiary removes money from the IRA, he must pay income tax on the distributions. This is similar to what the decedent would have done had she lived and taken distributions from the account.