Inheritance Tax vs Estate Tax: The Complete Guide

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Paul Sundin, CPA

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When a loved one dies, there are a lot of loose ends to tie up, starting with the tax situation. The IRS has its hand in the pot when there’s money being distributed from an estate. In this post, we examine the inheritance tax vs estate tax.

They are different and not everyone pays both. Here’s how they work.

What are Inheritance Taxes?

The federal government doesn’t charge an inheritance tax. They only charge an estate tax and not on every estate either.

Inheritance taxes are charged in six states – Iowa, Kentucky, Maryland, New Jersey, Nebraska, and Pennsylvania. Although Maryland collects both estate and inheritance tax, they are the only state to do so.

Inheritance tax means you pay money on the money you receive from your loved one if you live in one of the six states. However, the amount you pay varies based on the amount you receive AND your relationship with the deceased.

Scrabble pieces spelling TAX

In most cases, spouses, children, and some other close relatives don’t pay inheritance taxes but always check with your tax advisor to see how you line up.

If you owe inheritance tax – you pay it out of your own funds after you receive the money from the deceased’s estate.

What are Estate Taxes?

An estate tax is levied BEFORE the money passes to beneficiaries. The federal government charges estate taxes only after the estate is worth more than $11.7 million. Any amount above this threshold is taxed, but any amount under it isn’t.

Some states charge estate taxes too including:

  • Connecticut
  • Hawaii
  • Illinois
  • Maine
  • Maryland
  • Massachusetts
  • New York
  • Oregon
  • Rhode Island
  • Vermont
  • Washington
  • Washington D.C.

Like the federal government, most states have an exemption amount, decreasing the tax liability of the estate.

Estate taxes are paid from the estate and decrease the amount of money left to pay to the beneficiaries. You can set up your estate to avoid estate taxes by limiting its value, setting it up in a trust, give gifts, and make charitable donations.

Example of an Inheritance Tax

Inheritance tax is tax paid by the beneficiary. In other words, you pay to receive funds. In the six states that charge the tax, it’s manageable, but it’s still a tax.

Before you pay the tax, determine if you’re exempt. Many states have exemptions for spouses, children, grandparents, parents, siblings, and even in-laws or step-relatives. Talk to a tax advisor to ensure you must pay inheritance tax.

Here’s an example.

Joe received $100,000 from his friend when he died. Joe wasn’t expecting this inheritance, but he received it and he doesn’t fit in any of the boxes as a relative. He is a friend with no blood or step relation to the deceased.

Joe’s tax rate is 10% on the inheritance, so Joe must pay $10,000 on the money he received, leaving him with $90,000 from the inheritance.

Now if Joe was a relative, let’s say a spouse, he wouldn’t pay any taxes on the money, and would walk away with $100,000. If Joe was a brother, though, in some states, he may get an exemption of $1,000, leaving him with a tax liability on the $99,000.

Example of an Estate Tax

The estate tax is a tax on the entire amount of the estate, not the individual amounts given to beneficiaries. The estate pays the taxes, not the beneficiaries.

At the estate level, you must look at both the federal and state tax liabilities. At the federal level, the estate must be worth less than $11.7 million to avoid taxation.

Here’s an example.

Joe’s estate is worth $15 million when he dies. He has debts totaling $2 million. This leaves him with a net estate of $13 million which exceeds the $11.7 million threshold. This means Joe’s estate owes taxes on the $1.3 million that exceeds the limit.

Joe lives in New York, so his estate will also pay estate tax at the state level. The state tax exemption in New York is $5,930,000. Since Joe’s estate is worth more than this amount, the estate will pay federal and state taxes.

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The estate pays the taxes and distributes the assets accordingly. If the beneficiaries live in any of the six states that collect inheritance tax, they will pay inheritance tax too. If not, they won’t pay inheritance tax.

Now let’s say Joe’s estate was worth $5 million. His estate would not have to pay federal or state taxes since it’s lower than the exemption at both the federal and state level. But, depending on where Joe’s beneficiaries live, they may pay taxes on the money they inherit. This is a great way to analyze the inheritance tax vs estate tax.

How to Avoid Estate or Inheritance Tax

There’s no foolproof way to avoid estate or inheritance tax. It’s part of the tax law and something we all must abide by, but there are a few ways to minimize the cost:

  • Setting up a trust (giving up control of some of your assets)
  • Giving money to charity
  • Giving gifts while you’re alive

The high exemption rates, however, make it easy to get around the taxation. Since most estates are worth less than $11.7 million, you can save at least at the federal level. If you know you live in a state that charges estate tax, it’s important to plan ahead so you minimize the tax liabilities of your estate and your beneficiaries.

Inheritance Tax vs Estate Tax

You can’t escape taxes, but you can plan for them. Talk with a tax advisor about your estate and your intent for your beneficiaries. Try to minimize the cost of the taxes both sides will pay so you leave your loved ones with the money you intended to leave them with rather than sending it to the government.

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