Are Estate Distributions Taxable?

Usually not, but there are some exceptions

Practically speaking, the U.S. no longer has an inheritance tax. Inheritances of cash or property are not taxed as income to the recipient. As of 2021, the estate tax, which the estate itself pays, is levied only on amounts above $11.7 million. The amount for 2020 is $11.58 million. What's more, a special provision of the law allows the estate of a surviving spouse to as much as double that exemption.  As a result, very few estates or their beneficiaries will owe any tax at all.

Key Takeaways

  • An inheritance is not subject to income taxes.
  • The federal estate tax now applies only to a tiny minority of super-wealthy taxpayers, estimated at about 2,000 a year in total.
  • Income from traditional IRAs that are inherited will be taxable when the beneficiary takes distributions.

As of 2021, 17 states have an estate or inheritance tax. Five states have only an inheritance tax, and these are Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania. However, none of those states taxes inheritances that go to the spouse or children of the deceased. When they are levied, the taxes go up to 16% of the inheritance.

A Rare Case When Taxes Are Due

Estates, like individuals, must file income tax forms. They may owe taxes, too, if the assets in the estate are still earning interest or dividends, for example. If the estate executor has failed to pay income tax prior to distributing the inheritance, the beneficiaries may owe some tax.

The estate may pay the taxes due or distribute the taxable income to the heirs. In some cases, doing the latter actually saves the beneficiary money, as the estate may be in a higher tax bracket than the individual who is receiving part of the inheritance. The inheritance is recorded on the IRS Schedule K-1.

When IRAs Are Involved

While beneficiaries don't owe income tax on money they inherit, if their inheritance includes an individual retirement account (IRA) they will have to take distributions from it over a certain period and, if it is a traditional IRA rather than a Roth, pay income tax on that money. The IRS explains the rules in Publication 590-B.

Why No Estate Tax?

The history of the estate tax in the U.S. has been fraught with controversy. It was often derided by its opponents as a "death tax."

In less loaded terms, the estate tax was seen as particularly unfair to Americans whose family assets were tied up in property rather than cash in the bank. They would be forced to sell the property to pay the estate tax. This was seen as particularly egregious for family farmers whose wealth was tied up in farmland, equipment, and livestock.

Limiting the Tax

An exemption to the federal estate tax for estates of up to $5 million was put in place in 2010. That exemption has been reaffirmed and the limits have been raised in subsequent legislation passed by Congress. Current law exempts up to $11.58 million from estate taxes in 2020 and up to $11.7 million in 2021.

Getting Around the Tax

It is estimated that about 2,000 Americans a year are subject to estate taxes under the latest law, and they generally employ accountants who are adept at finding ways to avoid or minimize the estate tax.

One of the more popular methods of avoiding any estate tax is to give away portions of the estate in advance to family members. Another is to create an irrevocable life insurance trust.

Article Sources
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  1. Internal Revenue Service. "Estate Tax."

  2. United States Department of Agriculture. "Federal Estate Taxes."

  3. Internal Revenue Service. "Instructions for Form 706."

  4. AARP. "17 States With Estate or Inheritance Taxes."

  5. Internal Revenue Service. "Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR (2020)."

  6. Internal Revenue Service. "The Estate Tax: Ninety Years and Counting," Page 118.

  7. Internal Revenue Service. "The Estate Tax: Ninety Years and Counting," Pages 126-127.

  8. 111th Congress, 2nd Session. "H.R.4853 - Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010."

  9. Senate Committee on Finance. "Estate Tax Schemes: How America's Most Fortunate Hide Their Wealth, Flout Tax Laws, and Grow the Wealth Gap," Page 8.

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