Inheritance taxes are applicable on the bequest that a beneficiary receives. The tax rules and rates can vary from one jurisdiction to another. For example, in the US, there are no federal inheritance taxes.
Most states have also repealed inheritance taxes in the US. There are only six states that have inheritance taxes. However, you may be subject to these taxes even if you do not live in these states as it depends on which state the deceased person lived.
Let us discuss what is inheritance tax and how it is different from estate tax.
Inheritance Tax – Introduction
Inheritance tax is levied upon inherited assets from someone who has died. The person who inherits these assets pays this tax.
In the US, there is no federal inheritance tax. There are only six states in the US that charge inheritance taxes. Tax rates vary by state for taxpayers.
Tax rules for inherited assets vary by jurisdiction. The exempted amount, tax slabs, and effective tax rates are different as well.
The six states that have an inheritance tax and their tax rates are:
- Lowa, 0 to 15%
- Kentucky, 0 to 16%
- Maryland, 0 to 10%
- Nebraska, 0 to 18%
- New Jersey, 0 to 16%
- Pennsylvania, 0 to 15%
The spouse is exempted from the inheritance in all six states. Some states have also exempted the descendants and domestic partners from these taxes. Additionally, life insurance plans are also exempted from these taxes in all six states.
How Do Inheritance Taxes Work?
There are no federal inheritance taxes. Inheritance taxes are applicable in only six states in the US. The spouse is exempted from paying these taxes in all states.
Only two states Nebraska and Pennsylvania impose inheritance taxes on children and grandchildren on inherited assets. All other states do not impose taxes on transferred assets.
Distant heirs like siblings, nephews, and friends are subject to inheritance taxes. Effective tax rates depend on the relationship with the heir and the taxable amount.
General rules for inheritance taxes can be listed as:
- The spouse and some close family members such as children and grandchildren are exempted from inheritance taxes in most states.
- In some states, domestic partners and descendants are also exempt from these taxes.
- Effective tax rates are higher for distant heirs such as friends and lower for close heirs such as siblings.
- Inheritance tax is applicable if the deceased person lived in a state with an inheritance tax imposed.
- Even if the deceased person and heirs lived in two different states, heirs may get taxed for inherited assets depending on the state of the deceased person.
Inheritance Tax v Estate Tax
Estate taxes are federal taxes first. The estate tax rate for the federal government is up to 40%. However, some states also collect estate taxes. It means taxpayers can be taxed twice in some cases.
Estate taxes are owed by the estate. These taxes are applicable on all assets including property, cash, stocks, and other items. Estate taxes are levied upon the total value of all assets before they get distributed.
The exemption for federal estate taxes is $ 11.7 million as of 2021. Estate taxes payable for back years can vary (generally lower than the current year). So, estate taxes will be applicable on the value of total assets (estate) above this exempted limit.
The states that collect estate taxes have different exemption limits and tax rates. However, the tax is only applicable on amounts above the exempted limits in all states.
Example of Estate Tax
Suppose Mr. Smith owned total assets worth $ 7.5 million. He had a mortgage balance of $ 1 million. His other bank liabilities including credit card and other loans were $ 500,000.
For federal estate taxes, Mr. Smith’s estate does not owe any taxes. His estate is well below the exempted amount of $ 11.7 million.
Suppose Mr. Smith’s state has an estate tax with an exemption of $ 1.5 million and a 15% rate. Then,
Total Estate = $ 7.5 million Total Liabilities = $ 1.5 Million
Exemption = $ 1.5 million Taxable Estate = $ 4.5 million
Estate Tax Payable = $ 4.5 × 15% = $ 0.675 million or $ 675,000.
Mr. Smith’s beneficiaries will receive a net of $ 3.825 million.
Example of Inheritance Tax
Continuing with our example above, suppose Mr. Smith’s state has an inheritance tax applicable at 15%. He had a vehicle worth $ 500,000 that he left for his best friend Mr. Roger. Since Mr. Roger is a distant heir, inheritance tax applies to the value of the vehicle.
Mr. Smith’s vehicle is included in his total estate. Assume he did not make any instructions or a will about inheritance taxes. Then, Mr. Roger will have to pay $ 75,000 inheritance tax before he could claim the vehicle.
How to Reduce Inheritance and Estate Taxes?
There are no federal inheritance taxes. However, estate taxes are levied at the federal tax rates first. They are applicable on the estate before distributions.
It means the bequest would reduce for beneficiaries when estate taxes at federal rates are applied. Fortunately, the IRS allows a generous exemption limit of $ 11.7 million as of 2021.
Some states impose inheritance tax and some impose estate taxes. So, in some cases both taxes are applicable.
These taxes often collectively called “death taxes” are applicable where the deceased lived. Even if the beneficiaries lived in other states, they may end up paying the inheritance or estate tax bill.
Here are a few steps that you can consider to lower the “death tax” bill.
Know the Rules
Familiarize yourself with the estate and inheritance rules. You may end up being surprised when you receive a tax call for inheritance or estate tax bills. Particularly, if the deceased and the beneficiaries live in different states.
If there is any little you can do about “death taxes”, it is to talk to someone you expect to receive an inheritance from. In most cases, spouses and children are exempted from inheritance and estate taxes.
another way is to convince your loved ones to plan for taxes. There are several tax-saving strategies including using gifts and donations to reduce these taxes.
Set Aside Funds
As a last resort, you can set aside funds for estimated taxes. For estate taxes, if you do not make tax payments, the IRS has the authority to deduct these taxes from estate value.
Inheritance Taxes v Estate Taxes v Gift Taxes
Inheritance and estate taxes are different from gift taxes. These taxes are linked somewhat when a person uses gifts to reduce estate or inheritance taxes.
Unlike the common notion, you owe IRS gift taxes on all gifts above exempted amount.
A gift is any property that one person transfers to another with no or lower return. This includes the transfer of cash, house, property, stocks, and other assets.
The exempted amount for gifts is $ 15,000 per year as of 2021. Qualified charitable donations are also exempted. All other gifts above this threshold are taxable.
Some exemptions for gift taxes include:
- Tuition or medical expenses
- Gifts within the exempted allowance of $ 15,000
- Gifts to your Spouse
- Gifts to a political party
- Qualified Charitable Donations
A person may include gifts as a measure to reduce inheritance or estate gifts. However, the person must establish a history of giving gifts before claiming exemptions. The IRS may not allow all gifts or donations without any proof.