An inheritance tax is a state levy that Americans pay when they inherit an asset from someone who’s died. There’s no inheritance tax at the federal level, and how much you owe depends on your relationship to the descendant and where you live. As of 2021, just six states charge an inheritance tax, according to the Tax Foundation, and many beneficiaries are exempt.
Inheritance tax vs. estate tax: How they differ
Americans’ assets don’t escape taxes after death. Taxable property can be cash and securities, as well as real estate, insurance, trusts, annuities and business interests, according to the Internal Revenue Service (IRS).
The most common “death taxes” Americans might see are inheritance taxes and estate taxes, though both are different.
The main difference between an estate tax and an inheritance tax is that the former comes directly out of the deceased person’s estate before that asset is distributed to its beneficiaries. Meanwhile, the beneficiary is responsible for paying the inheritance tax as soon as they receive those assets.
Estate taxes come with high income thresholds, meaning most middle- to low-income Americans’ estates won’t be charged a tax bill.
To determine how much you owe at the federal level, you’ll want to calculate how much of your estate is taxable by subtracting the estate’s gross value with any debts and expenses that are also passed on to qualifying beneficiaries. A filing is required in 2021 if the estate’s value is determined to be higher than $11.7 million, according to IRS guidelines.
Federal estate taxes work like federal income taxes — estates are charged a graduating tax rate that increases per every dollar amount that goes above the filing threshold. The tax rate begins at 18 percent on the first $10,000 in taxable transfers over the $11.7 million limit and reaches 40 percent on taxable transfers over $1 million, according to an explanation from the Congressional Budget Office.
Twelve states and the District of Columbia also impose an estate tax, according to the Tax Foundation. Those are: Connecticut, Hawaii, Illinois, Maine, Minnesota, Maryland, Massachusetts, New York, Oregon, Rhode Island, Vermont and Washington.
Tax rates in those states range from as high as 20 percent to as low as 10 percent.
When it comes to those who are obligated to file, Massachusetts and Oregon have the lowest exemption level of any state, at $1 million, while Connecticut exempts estates from paying its estate tax as long as the total value is less than $7.1 million.
The executor of the estate is responsible for making sure these levies are paid.
Once the estate has paid all required estate taxes and settled any financial obligations, it can pay out the remaining assets to inheritors — who then become responsible for settling inheritance taxes. Their taxable amount is based on the specific amount distributed to them, rather than the total size of the estate.
Tax rates also depend on the beneficiary’s relationship to the deceased. Spouses, for example, are always exempt from paying inheritance taxes. Immediate relatives, such as children, are also often exempt or pay some of the lowest inheritance tax rates. Beneficiaries who are nonrelatives end up paying the highest tax rates.
Who has to pay? These states have an inheritance tax
Inheritance tax rates differ by the state. As of 2021, the six states that charge an inheritance tax are:
- Iowa (0-15 percent);
- Kentucky (0-16 percent);
- Maryland (0-10 percent);
- Nebraska (1-18 percent);
- New Jersey (0-16 percent); and
- Pennsylvania (0-15 percent).
Maryland is the only state to charge both an inheritance and an estate tax, meaning the total value of a deceased individual’s estate could be hit twice with levies. However, the state’s top inheritance tax rate — 10 percent — is the lowest of any of the six states, and children, spouses, parents, grandparents, stepchildren, stepparents, siblings or other direct lineal descendants are all exempt.
Nebraska has the highest top inheritance tax rate — 18 percent — that’s charged to nonrelative heirs. Children, however, are charged a 1 percent tax rate, while nephews and nieces get taxed at 13 percent.
Pennsylvania, meanwhile, is the only other state besides Nebraska that has decided to charge lineal heirs (children and grandchildren), with their tax rate being 4.5 percent.
How to avoid paying an inheritance tax
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.
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.
Give assets away before dying
If you think you’re going to get hit with sizable inheritance and estate taxes, you might want to give away some of your assets before you die. The IRS generally excludes gifts of up to $15,000 per person each year from taxes.
Move to a different state before dying
You might choose to relocate to a state that charges neither an inheritance tax nor an estate tax to limit how much of your wealth ends up going to the government after you die. When it comes to an inheritance tax, the state where the deceased person lives is what matters, not the beneficiary’s residence. For example, someone living in New Jersey doesn’t have to pay an inheritance tax if they inherited assets from someone who lived in Montana.
Utilize a trust
A trust allows a third party, or a trustee, to hold and direct assets in a trust fund on behalf of a beneficiary. It allows someone to place assets in a trust while they are still alive, while control of the trust is transferred after death to a designated beneficiary.
There are two types of trusts: revocable and irrevocable. With an irrevocable trust, there’s no official property transfer upon death, meaning no estate or inheritance taxes.
Work with a tax expert
An expert 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.
Does an inheritance count as taxable income?
For tax purposes, an inheritance isn’t normally considered taxable income unless it’s generating frequent returns, such as a rental property or an asset that provides interest or dividend payments. It also applies to withdrawals you’re taking from an inherited 401(k) or IRA.
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.
Not all Americans are charged an inheritance or estate tax, and many states have moved away from these levies altogether. However, these “death taxes” are still something you’ll want to keep a careful eye on if you’re hoping to pass on wealth to your spouse, children or any other heirs.