Planning is an important part of understanding and controlling your finances. While it’s nice to receive an inheritance, not knowing how it might impact your taxes and other income-based reporting can cause stress.
The short answer to whether you pay taxes on an inheritance is no, yet there are exceptions to that rule. Discussing your situation with a tax and estate planning professional can dispel any concerns and inform your future tax planning.
Clarity on Inheritance Reporting: No Taxes Due
Knowing the specific circumstances when an inheritance will and will not trigger additional taxes is critical knowledge, yet many people are unaware of the distinctions. Illinois residents in particular are unlikely to pay any additional taxes on inherited assets.
The following are the basic guidelines for when to report—or not report inheritances on your taxes:
- Inheritances are not considered taxable income most of the time. Inherited sums are not reported as income on your taxes. This includes real estate, stocks, personal property, cash, and life insurance payouts. Illinois does not tax inheritances.
- Taxes may be owed on any income that inherited assets generate. This includes interest accrued on cash or bank accounts that you inherit, dividends from inherited stocks or mutual funds, and rental income from inherited real estate.
- Capital gains taxes may be owed after the sale of an inherited asset like a home or a portfolio of stocks. This tax is calculated by the increase in value of the item between the time you inherited it and when you sold it. “Stepped up basis” is the term used to describe the fair market value of the item at the time it was inherited.
- Some types of inherited assets are treated differently for taxes. This includes withdrawals or distributions from 401(k) accounts and IRAs, which are taxed as income. Also taxable as income but less common is “income in respect of a decedent” which can be wages or retirement plan distributions that you’ve inherited. Also note that spouses who inherit retirement accounts like 401(k) have many options for receiving disbursements over time but others who inherit these accounts must empty them within 10 years, so planning for the impact of that income on taxes is important.
When does estate tax apply? Illinois does not impose an inheritance tax, nor does the federal government. Yet both require estate taxes when an inheritance exceeds a specific amount. For the federal government, the threshold for estate tax is about $15 million (periodically adjusted), and Illinois’ estate tax threshold is $4 million. If the tax applies, the estate pays it before the inheritance is passed to heirs.
Planning distributions from inherited retirement accounts or stock portfolios is important, because the income can skew your tax bracket higher. Similarly, selling an inherited property may push the value of your future estate over the threshold for Illinois estate tax. Talk to an estate planner about reducing that tax exposure, perhaps by creating a generation-skipping trust, through charitable gifts, and lifetime gifting strategies.
A trusted tax attorney or accountant can explain your responsibilities for taxes when inheriting property, accounts, stocks, or personal assets, because tax laws are very specific, applying to some but not all income.
Work With an Expert to Plan Your Financial Future
A tax and estate attorney, specially trained in Illinois law, can help make sense of inheritances and how they impact your taxes. They can review your investment accounts, real estate, or business interests, guiding you in reducing your tax exposure so that more of your hard-earned assets go to your beneficiaries. Call for a consultation today.