Understanding Inheritance Tax
Inheritance tax, a levy on assets passed down from a deceased individual, is a tax imposed by certain states on the recipients of inherited assets. Unlike an estate tax, inheritance tax is paid by the beneficiary of the inheritance rather than the deceased’s estate.
As of 2023, only six states in the U.S. have an inheritance tax. The taxation of an inheritance varies depending on factors such as the state where the deceased lived or owned property, the value of the inheritance, and the relationship of the beneficiary to the deceased.
Key Takeaways
- Inheritance tax is a tax on assets inherited from a deceased person.
- The tax is paid by the recipient based on the value of the inheritance received.
- There is no federal inheritance tax in the U.S.
- Residents of Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania may be subject to inheritance tax.
- Whether inheritance tax is payable depends on the inheritance amount, the beneficiary’s relationship to the deceased, and the state laws.
Understanding Inheritance Taxes
Unlike federal inheritance tax, which does not exist in the U.S., inheritance taxes are collected by six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
The imposition of inheritance tax is governed by factors such as the value of the inheritance, the relationship between the beneficiary and the deceased, and the state laws applicable at the time of the deceased’s passing.
When the Tax Applies
Whether an inheritance is subject to tax and at what rate is determined by the value of the inheritance, the beneficiary’s relationship to the deceased, and the state laws at the time of the deceased’s passing.
Inheritance taxes may be levied by states where the deceased resided or owned property if those states have inheritance tax laws. The beneficiary’s state inheritance tax laws do not apply in this scenario.
Typically, inheritance tax is triggered only for inheritances that exceed a certain minimum amount. Approximately 2% of recipients end up paying inheritance tax.
It’s important to note that an inheritance tax differs from an estate tax. While an estate tax is imposed on the estate before distribution, an inheritance tax is paid by the beneficiaries of the bequest.
How Inheritance Taxes Are Calculated
Inheritance tax, if applicable, is only applied to the portion of the inheritance that exceeds an exemption amount. Taxes are usually assessed on a sliding scale, ranging from single-digit rates up to 15-18%.
For instance, if the inheritance tax applies to bequests over $100,000 and a recipient receives $150,000, they may owe taxes on the excess $50,000. Tax rates are determined based on the inheritance value.
- $50,000 x .10 = $5,000
- Tax bill is $5,000
Your exemption and tax rate depend on your relationship to the deceased rather than the inheritance amount. The closer the relationship, the higher the exemption and the lower the tax rate. Surviving spouses are exempt from inheritance tax in the mentioned states.
Inheritance tax exemptions also apply to domestic partners and descendants in specific states, varying based on the relationship to the deceased.
Life insurance payouts to named beneficiaries typically avoid inheritance tax, though estate taxes might apply if the policy benefits the estate or a trust.
Inheritance Tax Thresholds
In most states, inheritance tax applies to bequests over a set amount. For example, Iowa exempts estates valued at less than $25,000 from tax.
- In Maryland, inheritances below $50,000 are exempt from tax.
Specific exemptions apply to heirs, with varying tax rates based on the relationship to the deceased. Here is a breakdown by state:
- Iowa: Immediate family members and charities are exempt, with a tax rate ranging from 2% to 6%.
- Kentucky: Immediate family members get exemptions up to $1,000, with rates between 4% and 16%.
- Maryland: Immediate family and charities are exempt, with a flat 10% tax rate on others.
- Nebraska: Specific exemptions apply, and the tax rates range from 1% to 15%.
- New Jersey: Immediate family members are exempt, with tax rates between 11% to 16%.
- Pennsylvania: Spouses and minor children are exempt, with tax rates varying depending on the relationship.
Strategically gifting assets during your lifetime may help reduce inheritance taxes, as states typically do not tax gifts.
Inheritance Tax vs. Estate Tax
Inheritance taxes and estate taxes are distinct forms of taxation, though often conflated. An estate tax is levied on the deceased’s estate, while an inheritance tax is imposed on the inheritance received by the beneficiary.
While the rates and exemptions of estate and inheritance taxes might be similar, the responsibilities differ — estate tax is paid from the estate, while inheritance tax is the beneficiary’s obligation.
For detailed information on federal and state estate taxes and inheritance taxes, consult with a tax professional or attorney.