Dear Penny: My dad died and left me $500,000. Do I have to pay taxes on it?

Dear Penny,

My father died in Texas and left me approximately $500,000 after settling the estate. I am a resident of Pennsylvania. Is there any way to avoid having to pay taxes on my inheritance?

— Drowning in the Gravy Train

Dear Drowning,

You can’t avoid duly owed taxes without illegal tax evasion. But the taxes you’ll owe on your inheritance will be minimal, as estate/inheritance taxes are designed to be.

When considering whether an inheritance is taxable, you have to consider a few types of taxes:

• Income tax.
  
• Federal estate tax.
  
• State inheritance tax.
  

Income tax is the amount you owe on money coming in — that’s what you report on a tax return each year. The IRS and the Pennsylvania Department of Revenue (DOR) both exclude inherited money or assets from taxable income. So you won’t owe income tax, usually the highest-rate tax you’ll pay, on this inheritance.

If you inherited income-generating assets, like property or investment accounts, you’ll have to start reporting any money you earn from those as income going forward.

The estate tax is a payment the federal government levies against the estate, not the recipient. That means it’s removed from the amount you’d inherit before you inherit it, and you don’t have to report it personally. But the IRS only levies this tax on estates worth millions of dollars — the cutoff is $12,920,000 for 2023. So you won’t owe that, either.

An inheritance tax is a tax a few states collect from the person who inherits money, assets or property. Pennsylvania is one of these states, and the tax rate depends on your relationship to the person who died. As a direct descendent to your father, your tax rate is 4.5%, or $22,500 of a $500,000 net inheritance. (It would be less if you still have to account for deductions, including debt and estate administration.) You’ll get a 5% discount ($1,125 based on the payment above) if you pay within three months, but you can set up a payment plan with the DOR if you’re unable or don’t want to pay the full amount at once.

Some inheritance is exempt from the Pennsylvania inheritance tax. Any farm land included might be exempt, and the entire estate is exempt if your father died as a result of injury or illness received while on active duty in the military.

A financial planner and tax preparer in your state can help with questions about your unique inheritance, and you can use the IRS’s interactive tax assistant to determine whether it considers your inheritance taxable. Find that at irs.gov/help/ita under “Is the Inheritance I Received Taxable?”.

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Dana Miranda is a Certified Educator in Personal Finance® and contributor to The Penny Hoarder. Send your tricky money questions to AskPenny@thepennyhoarder.com.