An inheritance tax is a state levy that Americans pay when they inherit an asset from someone who’s died, and is deemed a tax on your right to transfer property at your death. Inheritance tax is different from estate tax, and whether you pay might come down to the state you live in.
When a person passes away, their assets could be subject to estate taxes and inheritance taxes. This is depending on where they used to reside and how much they were worth. While the threat of estate taxes and inheritance taxes exists, the majority of estates do not charge federal estate tax because they are "too small".
While it's pretty uncommon for estates to be taxed, it's still possible. As of 2021, only if the assets of the deceased person are worth $11.70 million or more can be taxed. So who is left to pay the estate tax? Here's a look at understanding Estate and Inheritance Taxes and who is responsible for paying these taxes.
Estate or Inheritance? What's the Difference?
Inheritance tax is a state tax on assets inherited from someone who passed away. For federal tax purposes, inheritance generally isn’t considered income. But in some states, an inheritance can be taxable. The person who inherits the assets pays the inheritance tax, and tax rates vary by state.
Mainly those in the bigger states face these taxes, but the chances are you won't have to pay them. However, there are exceptions, and the specifics of your inheritance tax situation can dramatically change your tax bill.
The estate tax is a tax on a person's assets after death. In 2021, federal estate tax usually applies to assets over $11.7 million, and the estate tax rate ranges from 18% - 40%. Particular states also have estate taxes and they might have much lower exemption thresholds than the IRS. Assets that spouses inherit generally aren't subject to estate tax.
The main difference between an inheritance and estate taxes is the person who pays the tax:
- Estate Taxes: These are calculated based on the net value of all the property owned by a decedent as of the date of death. The estate's liabilities are subtracted from the overall value of the deceased's property to arrive at the net taxable estate. Any resulting tax bill is paid by the estate.
- Inheritance Taxes: These are calculated based on the value of individual bequests received from a deceased person's estate. The beneficiaries are liable for paying this tax, although a will sometimes provides that the estate should pick up this tab as well.
Why They Both Matter
For tax purposes, both federal and state taxes are assessed on the estate's fair market value. While that means appreciation in the estate's assets over time will be taxed, it protects against being taxed on peak values that have potentially dropped.
Anything included in the estate that is handed down to a surviving spouse and is not counted in the total amount isn't subject to estate tax. Spouses have the right to leave any amount to one another this is known as the unlimited marital deduction. When entering the situation of a surviving spouse who inherited an estate dies, the beneficiaries may then owe estate taxes if the estate exceeds the exclusion limit.
An heir can choose to decline inheritance through the use of an inheritance or estate waiver. The waiver is a legal document that the heir signs, declining the rights to the inheritance. In certain situations this waiver comes in hand when:
- An heir chooses to waive their inheritance to avoid paying taxes.
- To avoid having to maintain a house or other structures.
- Bankruptcy proceedings - so that the property can't be seized by creditors.
Federal and State Taxes
As mentioned above, for the tax year 2021, the Internal Revenue Service (IRS) requires estates with combined gross assets and prior taxable gifts exceeding $11.70 million to file a federal estate tax return and pay the relevant estate tax.
If you live in a state that has an estate tax, you’re more likely to feel its presence compared to when you have to pay federal estate tax. The exemptions for state and district estate taxes are all less than half those of the federal assessment. An estate tax is assessed by the state in which the decedent was living at the time of death. Here are the states that have estate taxes:
- Connecticut
- DC
- Hawaii
- Illinois
- Maine
- Massachusetts
- Maryland
- New York
- Oregon
- Minnesota
- Rhode Island
- Vermont
- Washington
While the decedent is responsible for estate taxes, the beneficiaries have to pay the inheritance tax. So, if you receive property in the event that someone passes, you might be liable to pay this tax. Only certain states use it, however, instead of the estate tax. They include:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
Among them, Maryland is the only one that uses both.
How to Keep Estate Taxes Low
To minimize estate taxes, keep the total amount of the estate below the $11.70 million threshold. For most families, that's easy to do. For those with estates and inheritances above the threshold, try and set up trusts that allow the transfer of wealth, this can help ease the tax burden.
Another way to reduce estate tax exposure is to use an intentionally defective grantor trust. This is a type of irrevocable trust that allows a trustee to isolate certain assets as a separate income tax from estate tax. The grantor pays income taxes on any revenue generated by the assets but the assets can grow tax-free. By doing this, it allows the grantor's beneficiary to avoid gift taxation.
There are ways to reduce estate taxes if you own a life insurance policy as well. On their own, life insurance proceeds are federal income-tax-free when they are paid to your beneficiary. One way to make sure things don't go awry, is to transfer ownership of your policy to another person or entity, including the beneficiary.
How to Avoid Inheritance Tax
In most cases, assets you receive as a gift or inheritance aren't taxable income at the federal level. However, if the assets you inherit later produce income (perhaps they earn interest or dividends, or you collect rent), that income is probably taxable. If you want to lower your estate’s tax burden and maximize the inheritance your beneficiaries receive, you’ll likely need to take steps before you pass away. You also want to watch out for capital gains taxes. If you sell any stocks, bonds, or other property that you received as part of an inheritance, capital gains taxes may apply to the profit you made.
Beneficiaries might not have much they can do to lower their bills, but they can work with their descendants or relatives on finding the best tax-saving strategy for passing on their wealth. These include strategies such as giving away assets before dying and possibly moving to a different state before dying.
Another way to help plan your assets and estate is to work with a financial advisor experienced in tax and estate planning. An trusted advisor can help you identify the best course of action for limiting your tax bill to ensure that you maximize the inheritance that you pass on to your beneficiaries.
Final Thoughts
Ultimately, the key difference between Estate and Inheritance tax comes down to who is financially responsible for the property transfer’s taxation. In the case of an estate tax, it is the deceased and their estate. By contrast, an inheritance tax requires the deceased’s inheritor or heir to pay to receive the assets.
Effective estate management enables you to manage your affairs during your lifetime and control the distribution of your wealth after death. An effective estate strategy can spell out your healthcare wishes and ensure that they're carried out – even if you are unable to communicate. It can even designate someone to manage your financial affairs should you be unable to do so.
If you're looking for a firm that handles estate planning and ways to reduce your taxes in life and death, look no further! Agemy Financial Strategies has a wide range of experienced advisors waiting for your call. For more information on our services, contact us today.