Inheritance Tax: What It Is, How It’s Calculated, Who Pays It

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Inheritance Tax: What It Is, How It’s Calculated, Who Pays It

What Is Inheritance Tax?

Some states levy an inheritance tax on the receivers of inherited assets. Unlike an estate tax, an inheritance tax is paid by the beneficiary of a gift rather than the deceased’s estate.

The tax is uncommon in the United States, and whether it applies in one of the six states that have an inheritance tax as of 2022 is determined by the state in where the dead resided or had property, the amount of the bequest, and the beneficiary’s connection to the decedent.

Key Takeaways

  • Inheritance tax is a tax levied on assets left to heirs of a dead individual.
  • In contrast to the estate tax, which is charged on the value of an estate and is paid by it, an inheritance tax is assessed on the value of the inheritance received by the recipient and is paid by the beneficiary.
  • There is no federal inheritance tax, although inherited assets in Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania may be taxed.
  • The size of the inheritance and your connection to the dead determine whether you must pay inheritance tax; smaller sums acquired from close relatives are more likely to be excluded.
  • Inheritance taxes may be reduced or avoided by leaving money to heirs via trusts or insurance policies, or by making gifts during one’s lifetime.

Understanding Inheritance Taxes

An inheritance tax differs from an estate tax. An estate tax is levied on the estate before its assets are transferred, while an inheritance tax may be levied on the recipients of a donation.

In the United States, there is no federal inheritance tax. While the United States government taxes big estates directly by imposing estate taxes and, if applicable, income taxes on any estate revenues, it does not levy an inheritance tax on persons who acquire assets from an estate.

Six states in the United States collect inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Your inheritance will be taxed, and at what rate, depending on its worth, your connection to the deceased, and the laws in your jurisdiction.

The state or states where the deceased resided or had property may levy an inheritance tax.

How Inheritance Taxes Are Calculated

If an inheritance tax is owed, it is only applied to the part of the bequest that exceeds an exemption level. Tax is normally levied on a sliding scale over such limits. Rates often start in the single digits and escalate to 15% to 18%. Both the exemption and the rate you pay may change depending on your connection to the dead, more so than the amount of the assets you inherit.

In general, the greater your family link to the dead, the greater the exemption and the lesser the fee you will pay. In all six states, surviving spouses are immune from inheritance tax. Domestic partners are excluded as well in New Jersey. In Nebraska and Pennsylvania, descendants are solely liable to an inheritance tax.

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In most cases, life insurance payable to a specified recipient is not subject to inheritance tax. If the insurance was the beneficiary of an estate or a revocable trust, it may be liable to an estate tax.

Inheritance Tax Thresholds

Most states impose an inheritance tax on bequests in excess of a particular sum. The size of the estate is crucial in a few cases. As an example:

  • When property transfers to the receivers in Iowa, no tax is owed if the estate is worth at less than $25,000.
  • In Maryland, inheritances from estates worth less than $50,000 are excluded as well.

There are further exemptions for heirs based on their relationship to the dead. Here are the specifics for each state:

  • Iowa:Immediate family members (spouses, parents, children) are exempt; charities exempt up to $500. The tax rate on others ranges from 5% to 15% of inheritance.
  • Kentucky:Immediate family members (spouses, parents, children, siblings) are exempt; other recipients exempt up to $500 or $1,000. The tax is on a sliding scale based on the size of inheritance and includes a minimum amount, plus a percentage ranging from 4% to 16%.
  • Maryland: Immediate family (parents, grandparents, spouses, children, grandkids, and siblings) and charitable organizations are exempt; other beneficiaries are exempt up to $1,000. The tax rate is set at 10%.
  • Spouses and charities are totally exempt in Nebraska; immediate relatives (parents, grandparents, siblings, children, and grandkids) are exempt up to $40,000. Other family members are exempt up to $15,000, while unrelated heirs are exempt up to $10,000. Above such exemptions, the tax rates are 1%, 13%, and 18%, respectively.
  • Immediate family (spouse, children, parents, grandparents, grandkids) and charity organizations are exempt in New Jersey. Siblings and sons/daughters-in-law are exempt up to a maximum of $25,000. Depending on the extent of the bequest and the family link, the tax rate varies from 11% to 16%.
  • Spouses and small children are excluded in Pennsylvania. Exemptions are available for adult children, grandparents, and parents up to $3,500. Depending on the connection, the tax rate is 4.5%, 12%, or 15%.

Inheritance Tax vs. Estate Tax

Inheritance taxes and estate taxes are often combined. They are, however, two separate types of taxes.

Both levies are based on the fair market value of a dead person’s property as of the date of death, which is generally the day of death. However, an estate tax is assessed on the value of the decedent’s estate and is paid by the estate. An inheritance tax, on the other hand, is charged on the value of an inheritance received by the recipient and is paid by the beneficiary.

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A solitary heir may not notice the difference between an estate tax and an inheritance tax with comparable rates and exemptions. However, in very rare cases, an inheritance may be liable to both estate and inheritance taxes.

The Internal Revenue Service (IRS) claims that federal estate tax reports are only needed for estates worth more than $11.7 million in 2021 and $12.06 million in 2022. There is no estate tax if the dead person’s estate goes to his or her spouse.

If a person inherits a substantial enough estate to trigger the federal estate tax, the deceased resided or held property in a state with an inheritance tax, and the gift is not totally exempt under that state’s legislation, the recipient must pay both the federal estate tax and the state inheritance tax. Before it is disbursed, the estate is taxed, and the inheritance is then taxed at the state level.

In addition, heirs may be subject to a state estate tax. Connecticut, District of Columbia, Hawaii, Illinois, Maine, Massachusetts, Maryland, New York, Oregon, Minnesota, Rhode Island, Vermont, and Washington still collected estate taxes as of 2022: Connecticut, District of Columbia, Hawaii, Illinois, Maine, Massachusetts, Maryland, New York, Oregon, Minnesota, Rhode Island, Vermont, and Washington.

Maryland is the only state that levies both an estate and an inheritance tax.

If you reside in a state that has 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 states have estate tax exclusions as low as $1 million.

Avoiding Inheritance Tax

While there are many exclusions and exemptions for inheritance taxes, particularly for spouses and children, people with large assets in a state with one may nevertheless desire to reduce heirs’ exposure.

One frequent technique is to get a life insurance policy in the amount you want to leave to the person you want to leave it to as the policy’s beneficiary. An insurance policy’s death payout is not subject to inheritance taxes.

You might also place assets in a trust, especially one that is irreversible. This essentially eliminates them from your estate and their inheritance status following your death. When you create the trust, you may choose when the money will be distributed.

Trusts are intricate beasts that must be properly and methodically set up and stated in order to comply with state tax rules. So don’t do it without the assistance of a trust and estates attorney.

Instead of a lump-sum bequest upon your death, consider donating money to beneficiaries gradually while you’re still living. Most states do not tax gifts.

How Much Can You Inherit Without Paying Taxes?

The six states in the United States that have inheritance taxes allow varied exemptions depending on the quantity of the bequest and the heir’s family tie to the dead. As of 2022, the federal estate tax exemption is worth $12.06 million. Inheritances are not subject to income tax.

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What Is the Federal Inheritance Tax Rate?

There is no federal inheritance tax, which is a tax on the total amount of assets received from a dead person. However, a federal inheritance tax is imposed on estates worth more over $11.7 million in 2021 and $12.06 million in 2022. The tax is only levied on the part of an estate that exceeds such limits. The rate is variable, ranging from 18% to 40%.

Do Beneficiaries Have to Pay Taxes on Inheritance?

It is determined by their family link to the dead as well as the state in where the decedent resided or held property. Only estates or property situated in one of the six states that levy inheritance taxes may be taxed.

Surviving spouses are never subject to inheritance taxes. Other close relatives, such as the deceased’s parents, children, and siblings, are excluded to varied degrees in different states. They may be entitled to a tax-free inheritance and a reduced tax rate on the rest.

Inheritance taxes mostly impact second cousins and unrelated heirs.

How Is Inherited Tax Calculated?

The regulations governing inheritance taxes differ from state to state. Most states categorize beneficiaries based on their familial tie to the dead (immediate, lineal, or unrelated), and establish exemptions and tax rates accordingly.

Most states only tax inheritances above a specified sum. They then charge a percentage of this amount, which might be flat or progressive. In Kentucky, for example, the rate varies from 4% to 16%, increasing as the bequest amount increases, from $1,000 to more than $200,000. It also levies a fixed dollar number dependent on the inherited sum, ranging from $30 to $28,670.

The Bottom Line

Only inhabitants of six states are subject to inheritance taxes. And they mostly apply to distant relatives or others who have nothing to do with the dead. Spouses are always excluded, as are close family members (children, parents). If siblings, grandkids, and grandparents are taxed at all, they enjoy preferential treatment (larger exemptions, lower rates).

Even yet, inheritance taxes may apply to very minor bequest sums, perhaps as little as $500. Consider estate-planning methods such as donations, insurance policies, and irrevocable trusts when making bequests that may be subject to an inheritance tax.

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