Whether you inherit one dollar or a million dollars, it's unlikely you'll have to pay tax on it. Inheritance isn't subject to income tax, there's no federal inheritance tax and any estate tax is owed by the estate, not you. There are circumstances that require you to pay tax on your inheritance, but they're the exception rather than the rule.
TL;DR (Too Long; Didn't Read)
Whether you are responsible for paying an inheritance tax or not depends on the laws of the state you live in and your relationship to the deceased.
Six states -- Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania -- impose an inheritance tax. The tax applies if you or the deceased are state residents, or if you inherit property in one of those states. In Iowa, tax kicks in if the total estate if worth $25,000; in Pennsylvania, any inheritance is taxable. All states offer exemptions for close relatives: children under age 21 and spouses pay no inheritance tax in Pennsylvania, for instance.
If the deceased named you as the beneficiary of her IRA or 401(k), federal taxes do kick in, but not immediately. Suppose the account is worth $38,000: you don't pay the IRS when you inherit, but whenever you withdraw money, it counts as taxable income. In most cases, you have to make mandatory minimum withdrawals every year until the account is empty. You add the value of the withdrawal to your other income for the year and pay whatever tax is due.
Sale of Inherited Property
When you inherit property and sell it -- a house, a car, a Picasso -- you may have to pay tax. If your father's house was worth $170,000 when you inherited it -- and the executor should be able to give you that information -- and if you sell it six months later for $190,000, you have $20,000 in taxable gains. You always pay the long-term capital gains tax rate on inherited property, no matter how long you hold it. If you have any expenses associated with the sale, such as a real estate agent's commission, you subtract them from your gains.
If the taxes are more than you want to deal with, you can always disclaim the inheritance. Disclaiming is a legal step that lets the property pass to whichever beneficiary is next in line: you never take ownership of the house or the money, so you have no tax obligation. Suppose you're a 25-year-old Pennsylvanian who inherits $25,000 from your father. You would pay 4.5 percent tax on the money if you accepted it, but if you disclaim it and your 15-year-old brother inherits, he's exempt.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.