As Benjamin Franklin stated over 200 years ago, “…in this world, nothing can be said to be certain except death and taxes.” The adage rings especially true where these two certainties intersect – namely, the inheritance tax.
When navigating a difficult end-of-life transition, money is likely the last thing grieving loved ones want on their minds, particularly with something as uninviting as taxes. Taking time to understand the basics of inheritance tax works can go a long way to alleviate this burden when the time comes to deal with some of life’s most challenging moments.
What Is an Inheritance Tax?
An inheritance tax is a tax burden an individual may owe after inheriting money or other assets.
Inheritance taxes are similar to estate taxes, which many Americans might more easily recognize. Both can be levied following an end-of-life event as a tax on assets moving from the deceased to their beneficiaries. However, there is one key difference: estate taxes are owed by the deceased’s (or “decedent’s”) estate before distributing assets to the beneficiaries. On the other hand, an inheritance tax falls on the beneficiary of the inheritance.
In the US, only six states collect an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
These states only account for around one-tenth of the US population, and not everyone who inherits money in these states is necessarily subject to an inheritance tax. While most Americans don’t have to worry about inheritance taxes, it is good to familiarize yourself with how they work and whether they could impact you.
Inheritance Taxes vs. Estate Taxes
There may be some confusion between inheritance and estate taxes, and for a good reason – the two most common forms of so-called “death taxes” are pretty similar, and the differences between them are somewhat nuanced.
To distinguish between the two, focus on the following three questions:
- Who owes the tax?
- Who collects the tax?
- When is the tax due?
An estate tax is the responsibility of the estate itself. The executor of the estate needs to pay these taxes before making any distributions to the inheritors. In the US, the federal government levies an estate tax, as well as the District of Columbia and twelve states:
- New York
- Rhode Island
In contrast, an inheritance tax is the responsibility of the person inheriting the money or property, more like an income tax. As a result, it isn’t due until after the estate distributes the inheritance. This type of tax is also far less common in the US, as only six states collect it.
All Americans are potentially subject to estate taxes at the federal level and possibly the state level too. Inheritance taxes impact comparatively few. However, it is possible in some scenarios to owe both, so it is crucial to familiarize yourself with the nuances and rules that may affect your estate planning.
You should also consider speaking with a qualified tax accountant knowledgeable in the nuances of any inheritance taxes applicable in your state.
How Does Inheritance Tax Work?
The specific rules for calculating inheritance tax vary from one state to the next, but the basic framework is reasonably consistent.
For starters, beneficiaries don’t owe anything on inheritance below a certain threshold; assets beyond that threshold typically incur tax along a sliding scale. The threshold varies between states, as does the scale.
The beneficiary’s relationship to the decedent can also affect the tax rate: for instance, spouses do not owe an inheritance tax in any of the six states that collect it.
In Iowa, inheritors will not owe an inheritance tax if the taxable estate value is less than $25,000. Spouses are exempt from inheritance tax. The same is true for direct ascendants (such as your parents, grandparents, and so on) and descendants (including your children, grandchildren, and so on) – basically, anyone directly up or down your family tree.
Iowa’s inheritance tax rates are agreeable, even for those not exempt. Iowa’s tax rate on eligible inheritance ranges from 3% to 9%.
In Kentucky, immediate family members of the deceased (including parents, siblings, spouses, and children) are fully exempt from inheritance tax. All others are exempt from tax on any inheritance below $500. Beyond that threshold, inheritors owe state tax rates from 4% to 16% on a sliding scale.
Maryland is the only state which collects both a state-level estate tax and an inheritance tax, so it is crucial to pay close attention here to make sure no one is over- or under-paying their taxes following the loss of a loved one in this state.
In Maryland, inheritances from estates valued below $50,000 are fully exempt from inheritance taxes. The same is true for legacies of any size that goes to immediate family members or charities. The first $1,000 of the inheritance is exempt for all other beneficiaries, and they will owe a 10% tax rate beyond that threshold.
Nebraska offers a full inheritance tax exemption to a surviving spouse or a charity but not to all family members.;
Non-spousal immediate family members are exempt from taxation on the first $100,000 of their inheritance. For other relatives, this exemption drops to $40,000. All other inheritors are exempt on the first $25,000. Beyond those thresholds, recipients owe inheritance tax at rates of 1%, 11%, and 15%, respectively.
Immediate family and charities are exempt from inheritance tax in New Jersey. Siblings and sons/daughters-in-law are not included with immediate family but are exempt on the first $25,000 of an inheritance.
For non-exempt assets, the tax rate sits on a scale from 11-16%. In addition to the amount of the inheritance, the beneficiary’s relationship to the decedent also impacts the rate on this scale.
In Pennsylvania, spouses and underage children do not owe inheritance tax. Other close relatives carry an exemption of up to $3,500. Depending on the beneficiary’s relationship to the deceased, the tax rate on non-exempt assets will be either 4.5%, 12%, or 15%.
Federal Inheritance Tax in The US
The United States does not impose a federal tax on inheritance. Only the six states described above will levy an inheritance tax on some heirs. However, inheritances outside the six states are not necessarily tax-free, as the US does collect estate tax at the federal level.
Estates with a valuation beyond $12.92 million will have tax due before distributing assets to inheritors. Estates below this threshold will owe no federal estate tax, but assets above it will have tax rates ranging from 18% to 40%.
Reducing Inheritance Tax Burden
Now, onto the always-burning question in taxation matters: how do you reduce the tax liability of an end-of-life transition involving your loved ones?
The first option is the simplest, if not necessarily the easiest: consider where you live. In choosing a retirement destination, one of the top factors for many households is selecting a home with favorable tax laws for late-in-life individuals, especially those with significant assets or considerable liquid net worth. This is not limited to whether or not the state collects a death tax and can also include favorable conditions around:
- Gift tax
- Capital gains tax
- Transfer tax
Spending your golden years in a beautiful location with a retirement-friendly tax code is appealing, but it may only be realistic for some. Fortunately, it’s not the only way to shield yourself and your loved ones from inheritance tax.
One option is to use insurance. Taking out a life insurance policy in the amount you want to leave to someone and setting them as the beneficiary is one way to pass that amount to them in the event of your death. Life insurance payouts are not subject to inheritance tax.
Finally, there’s no discussing ways to avoid end-of-life taxes without mentioning trusts. Trusts offer a variety of ways to give loved ones access to a pool of assets during one’s lifetime to shield heirs from hassles like probate and death taxes.
Maximizing Your Generational Wealth
Navigating the loss of a loved one is a chaotic and emotionally overwhelming time. Wading through complex logistics, state and federal law, and financial burdens is the last thing grieving individuals should have to deal with during these moments. Still, these are the burdens close friends and families must surmount all the same.
By familiarizing yourself with concepts like inheritance tax ahead of time, you can go a long way to prepare yourself and those close to you to ease some of the difficulty of these moments. Remember, you don’t have to go through this challenging time alone. Consider speaking with an experienced financial advisor near you who can offer guidance throughout the process.
You cannot make a loss entirely painless, but you can solve some problems ahead of time to reduce unnecessary challenges when the time comes.
Proper estate planning is more than doling out payments to heirs or trying to avoid taxes. It is an act of kindness to the people we love most – a deliberate effort to remain with them and guide them into the next stage of their lives. By preparing for the inheritance tax, you can add one more step to that preparedness.