When a person dies, their assets could be subject to estate taxes and inheritance taxes, depending on where they lived and how much they were worth. While the threat of estate taxes and inheritance taxes does exist, in reality, the vast majority of estates are too small to be charged a federal estate tax, which, as of 2021, applies only if the assets of the deceased person are worth $11.70 million or more. That exemption increases to $12.06 million in 2022.
What’s more, most states have neither an estate tax, which is levied on the actual estate, nor an inheritance tax, which is assessed against those who receive an inheritance from an estate.
Indeed, the number of jurisdictions with such levies is dropping, as political opposition has risen to what some criticize as death taxes. That said, a dozen states plus the District of Columbia continue to tax estates, and a half dozen levy inheritance taxes. Maryland collects both.
As with federal estate tax, these state taxes are collected only above certain thresholds. And even at or above those levels, your relationship to the decedent—the person who died—may spare you from some or all inheritance tax. Notably, surviving spouses and descendants of the deceased rarely, if ever, pay this levy.
It’s relatively uncommon, then, for estates and inheritances to actually be taxed. Still, it’s helpful to know more about the various taxes associated with these assets, and who needs to pay them, and when. Want to find out if you’re likely to be stuck with an estate tax or inheritance tax and what you can do to reduce any such taxes? Read on.
- The IRS establishes restrictions on estate valuations before they are taxed.
- A dozen states have estate taxes, and six have inheritance taxes, both of which have lower thresholds than the federal estate tax.
- The value of the estate or inheritance that exceeds the threshold amount is subject to federal and most state taxes.
- Regardless of the extent of the estate or bequest, surviving spouses are normally immune from these taxes.
- To reduce inheritance taxes, people with estates above the threshold might establish up trusts to assist asset transfer.
For tax purposes, these levies, both federal and state, are assessed on the estate’s fair market value (FMV), rather than what the deceased originally paid for their assets. While that means any appreciation in the estate’s assets over time will be taxed, it also protects against being taxed on peak values that have since dropped. For example, if a house was bought at $5 million, but its current market value is $4 million, the latter amount will be used.
Anything in the estate that is bequeathed to a surviving spouse is not counted in the total amount and isn’t subject to estate tax. The right of spouses to leave any amount to one another is known as the unlimited marital deduction. But when the surviving spouse who inherited an estate dies, the beneficiaries may then owe estate taxes if the estate exceeds the exclusion limit. Other deductions, including charitable donations or any debts or fees that come with the estate, are also not included in the final calculation.
An heir due to receive money or assets can choose to decline the inheritance through the use of an inheritance or estatewaiver. The waiver is a legal document that the heir signs, declining the rights to the inheritance. In such an instance, the executor of the will would then name a new beneficiary of the inheritance. An heir might choose to waive theirinheritance to avoid paying taxes or to avoid having to maintain a house or other structure. A person in a bankruptcy proceeding might also choose to sign a waiver so that the property can’t be seized by creditors. State law determines how the waivers work.
The top federal statutory estate tax rate in 2021 and 2022.
Federal Estate Taxes
As previously stated, for the 2021 tax year, estates with total gross assets and preceding taxable gifts over $11.7 million must file a federal estate tax return and pay the applicable estate tax. For 2022, the barrier rises to $12.06 million.
The part of the estate that exceeds this limit of $11.70 million will theoretically be taxed at the highest federal statutory estate tax rate of 40%. However, different reductions, deductions, and loopholes enable expert tax accountants to reduce the effective tax rate to much below that amount. Among these strategies is the use of flexibility in the estate’s valuation date in order to lower the estate’s value or cost basis.
State estate taxes are imposed by the state where the deceased resided at the time of death, while inheritance taxes are imposed by the state where the inheritor resides.
State Estate Taxes
If you reside in a state with an estate tax, you are more likely to be affected than if you pay federal estate tax. State and district estate tax exemptions are all less than half of the federal assessment. Some go as low as $1,000,000, in relative terms. The state in which the deceased resided at the time of death imposes an estate tax.
The following jurisdictions have estate taxes. Click on the state’s name for further information about the state’s estate tax from the state government.
Above certain levels, taxes are normally levied on a sliding scale, similar to income tax brackets. For sums slightly beyond the threshold, the tax rate is normally 10% or so, rising in stages to 16%. Connecticut has the lowest top estate tax rate, at 12%, while Washington State has the highest, at 20%.
The maximum rate for inheritance tax charged by any state.
State Inheritance Taxes
Although there is no federal inheritance tax, certain states, including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, nevertheless tax assets inherited from dead people’ estates. Your inheritance will be taxed (and at what rate) depending on its worth, your connection to the deceased, and the regulations and rates in effect where you reside.
Life insurance paid to a specified recipient is not normally subject to inheritance tax, however life insurance paid to the dead person or their estate is usually liable to estate tax.
An inheritance tax, like estate tax, is levied solely to the amount that exceeds the exemption. Above such levels, tax is normally levied on a sliding scale. Rates often start in the single digits and escalate to 15% to 18%. The exemption you obtain and the rate you pay may vary depending on your connection to the dead, more so than the amount of the assets you inherit.
In general, the smaller the fee you’ll pay, the tighter your connection with the deceased. In all six states, surviving spouses are immune from inheritance tax. Domestic partners are excluded as well in New Jersey. Except in Nebraska and Pennsylvania, descendants pay no inheritance tax. The state in which the inheritor resides assesses inheritance tax.
Some states provide tax breaks to widows and widowers, such as a decrease in property taxes for a certain length of time. In Florida, for example, a surviving spouse is entitled to a $500 decrease in the taxable value of a property they own each year in perpetuity, or until they remarry.
The following jurisdictions have inheritance taxes. Click on the state’s name for further information from the state government on its inheritance tax:
Maximize Your Gifts
Another strategy to decrease estate taxes is to maximize your donation possibilities. Individuals may contribute another $15,000 or less each year, and married couples can give $30,000 per year, without having to submit a federal gift tax return as of 2021. For 2022, the restrictions rise to $16,000 for individuals and $32,000 for married couples.
How to Minimize Estate Taxes
To reduce estate taxes, keep the planning simple and the overall value of the estate below the threshold. That is simple for most households. Setting up trusts to assist the transfer of wealth may help persons with estates and inheritances over the threshold reduce their tax burden.
An deliberately defective grantor trust (IDGT), a form of irrevocable trust that permits a trustor to isolate specific trust assets so that income tax and estate tax treatment on those assets are separated, is one strategy to decrease estate tax risk. The grantor must pay income taxes on the assets’ revenue, but the assets may grow tax-free. As a result, the grantor’s recipients are exempt from gift taxes.
If you also have a life insurance policy, you may lower your estate taxes. When life insurance funds are given to your beneficiary, they are tax-free at the federal level. However, if the earnings are included in your taxable estate for estate tax purposes, they may put your estate above the threshold. Transferring ownership of your insurance to another person or business, including the beneficiary, is one method to avoid this. Another option is to create an irrevocable life insurance trust (ILIT).
What Assets Are Subject to Estate Taxes?
Federal estate taxes apply to all assets of a dead individual valued at $11.70 million or more as of 2021. This figure rises to $12.06 million for the fiscal year 2022.
Estate taxes are also levied in twelve states and the District of Columbia, however the laws vary per jurisdiction.
What Is the Estate Tax Rate?
The amount of the estate that exceeds the $11.70 million and $12.06 million cutoffs will be taxed at a 40% rate beginning in 2021 and 2022, respectively.
The tax rate varies depending on where you reside, but the highest rate for an inheritance that may be levied by any state is 18%.
What Is the Difference Between an Estate Tax and an Inheritance Tax?
An estate tax is charged on the estate itself, whereas an inheritance tax is levied on individuals who inherit from an estate.
Do I Have to Pay Taxes on an Estate?
You must pay inheritance taxes if you get an inheritance from an estate and the assets are worth more than $11.70 million in 2021. The estate tax is imposed on the estate. Keep in mind that the threshold in 2022 is $12.06 million.
How Can I Avoid Estate Taxes?
One approach to avoid paying taxes is to keep your estate beneath the threshold. Other strategies include establishing trusts, such as an intentionally faulty grantor trust, which separates income tax from estate tax treatment, moving your life insurance policy so it is not recognized as part of your estate, and strategically using gifts.
The Bottom Line
Inheritance taxes are complicated and subject to frequent modification. Most of us interact with them at a stressful and hectic time in our lives. It’s a good idea to plan ahead of time by conducting some research.
As long as the estate’s assets do not reach $11.70 million in 2021 (or $12.06 million in 2022), you are unlikely to be subject to federal estate or inheritance taxes. However, keep an eye on particular states’ standards since a dozen states and the District of Columbia impose estate and inheritance taxes as well.
Keep an eye out for changes in the laws that impact you, maybe by setting up online news alerts for the state in question as well as the phrases estate taxes and inheritance taxes. As you become older, you may assist your loved ones in preparing for taxes by explaining the rules to them. You may even wish to set up a fund to assist offset the tax burden when it arrives. Consider consulting with a lawyer, CPA, or CFP to start arranging your inheritance and reducing the amount of tax your heirs will have to pay when they receive it.
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