Inheritance: Definition, How It Works, and Taxes

What Is an Inheritance?

Inheritance refers to the assets that an individual bequeaths to their loved ones after they pass away. An inheritance may contain cash, investments such as stocks or bonds, and other assets such as jewelry, automobiles, art, antiques, and real estate.

A person may name beneficiaries in their will who will receive an inheritance. In other cases, assets will automatically pass to a spouse or children as heirs.

Those who receive an inheritance may be subject to inheritance taxes, where the more distantly related a beneficiary is to the decedent, the larger the inheritance tax is likely to be. In the United States, assets can also be subject to federal and state income tax, though life insurance policy death benefits are typically tax-free for named beneficiaries.

Key Takeaways

An inheritance is a financial term describing the assets passed down to individuals after someone dies.
Most inheritances consist of cash that’s parked in a bank account but may contain stocks, bonds, cars, jewelry, automobiles, art, antiques, real estate, and other tangible assets.
Those who receive an inheritance may be subject to inheritance taxes, where the more distantly related a beneficiary is to the decedent, the larger the inheritance tax is likely to be.
Six U.S. states currently impose inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
A decedent’s assets are divided according to their will through the probate process. If there is no will, the court will appoint an administrator to divide assets according to state laws.

How an Inheritance Works

The value of an inheritance can range from a few thousand dollars to several million dollars. In most countries, inheritance assets are subject to inheritance taxes, where beneficiaries may find themselves saddled with tax liabilities. The rates of an inheritance tax (sometimes referred to as a “death duty” or “the last twist of the taxman’s knife”) depend on a host of factors, including a beneficiary’s state of residence, the value of the inheritance, and the beneficiary’s relationship to the decedent.

Currently, the six American states that have inheritance taxes are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. And in most of these states, any assets that are bequeathed to a spouse are exempt from inheritance taxes. In some cases, children are also exempt, or they may face lower rates of taxation.

An inheritance tax differs from an estate tax, which is a levy on the transfer of a deceased person’s estate. But estate taxes do not apply to assets left to a spouse or to federally recognized charities, in most cases.

Beneficiaries with no familial ties to the decedent are typically subject to higher inheritance taxes than beneficiaries who are closely related to the decedent. Consider the following example: In Nebraska in 2018, a parent, grandparent, sibling, child, or other lineal descendants (including adopted children) paid an inheritance tax of 1% on assets exceeding $40,000.

By contrast, relatives who were further removed from the decedent paid inheritance taxes of 13% on amounts over $15,000. All other beneficiaries, such as friends and far distant relatives, paid inheritance taxes at a rate of 18% on assets exceeding $10,000.

Life insurance is not subject to inheritance taxes. If you wish to avoid an inheritance tax, consider taking out a life insurance policy with your heirs named as beneficiaries.

The Probate Process

Probate is the legal process by which a decedent’s assets are divided among their heirs and beneficiaries, according to their will and state laws. If the decedent died with a will, that will is reviewed by a probate court, which appoints an executor for the decedent’s estate. The executor is then responsible for dividing the estate among the people named in the will and any creditors. Any disputes are resolved through probate court.

A person who dies without a will, or with an invalid will, is said to have died intestate. In this circumstance, the probate court will appoint an administrator of the estate to divide the assets according to state laws.

Beneficiaries vs. Heirs

There is a distinction between a beneficiary and an heir. Beneficiaries refer to individuals named in a will, while heirs refer to people such as a child or a surviving spouse, who are entitled to receive a decedent’s property, by “intestate succession.” This is a set of rules created to sort out inheritance matters in the absence of a will.

What Can You Do to Avoid Inheritance Taxes?

An inheritance tax is a state tax on the estate of a decedent. In most cases, inheritance taxes are higher according to the size of the inheritance and the beneficiary’s relationship to the deceased.

You can reduce the inheritance tax burden on your beneficiaries by placing your assets in a trust, or by gifting assets to your beneficiaries while they are still living. Another option is to take out a life insurance policy, naming your heirs as beneficiaries. These payouts are not subject to inheritance taxes.

How Can You Avoid Taxes on a 401(k) Inheritance?

If you inherit a 401(k) from a spouse, the conventional wisdom is to roll the sum into your own individual retirement account (IRA). This allows you to defer taxes until you start taking distributions.

If you inherit from a parent, it’s a little more complicated. The first step should be to consult the plan documents to determine what options are available. Most advisors caution against a lump-sum distribution, which would incur greater taxes than you would otherwise. A five- or 10-year distribution allows you to spread out the tax burden and allows interest to compound. Some plans also allow distributions over your calculated life expectancy, under very specific conditions.

Can You Protect an Inheritance from a Chapter 13 Bankruptcy?

If you receive an inheritance within 180 days of filing Chapter 13 bankruptcy, your trustee may require you to pay the sum into your bankruptcy plan. It’s more complicated for inheritances received more than 180 days after a bankruptcy filing—most courts have ruled that these windfalls should be repaid to creditors, but some courts have allowed the inheritor to keep the money.

How Do I Find Out If I Have an Unclaimed Inheritance?

According to the U.S. government, the first step to finding unclaimed assets is to check your state’s unclaimed money office. This is where the state collects records of unpaid wages, unclaimed bank accounts, and heirs who could not be located.

If you are uncertain about the contents of a will, the first step is to contact the decedent’s executor. In addition, their will should be filed with the local county recorder.

What Is Probate?

The term “probate” refers to a legal process in which the validity and authenticity of a will are determined. Probate also refers to the general administration of a deceased person’s will or the estate of a deceased person without a will.

After an asset holder dies, the court appoints an executor named in the will or an administrator (if there is no will) to administer the process of probate. This involves collecting the deceased’s assets to pay any liabilities that remain on their estate and to distribute the assets to beneficiaries.

The Bottom Line

Inheritance planning is an unpleasant but necessary task for those of advancing age. While nobody enjoys thinking about their death, a well-structured estate plan can save your heirs and beneficiaries from a lot of legal unpleasantries. Moreover, it can also ensure that they receive as much money as possible, without losing too much value in taxes.