Inheritance is a welcome gift! That gift might come with tax liabilities for some of the 38 million Americans who reside in states that impose inheritance taxes. Death and taxes are only certain things in life, and both are affected by inheritance taxes. It's a tax imposed on funds, real estate, or other assets that a deceased person passes to heirs. Inheritance tax is payable by the recipient, though the amount owed depends on several factors, including the deceased's residence and their relationship to the beneficiary. In this article, we will discuss inheritance tax and how it's calculated.
What is Inheritance Tax?
When someone passes away and leaves their possessions to another person, the beneficiary might have to pay an inheritance tax to the government. Some US states levy a tax on those who inherit property. An inheritance tax differs from an estate tax in that it is paid by the recipient of a property instead of the dead person. Inheritance taxes are uncommon in the United States. As of 2024, there are just six states with inheritance taxes.
Inheritance taxes are based on the worth of an inheritance, the relationship between the beneficiary and the decedent, and the state where the dead person lived or owned property. The beneficiary is responsible for paying the inheritance tax based on the inheritance they received. Individuals can inherit assets such as jewelry collections, real estate, and retirement accounts. Their worth is used to determine inheritance tax.
What states have inheritance tax?
Inheritance taxes are levied on beneficiaries in just six states in 2024:
- Iowa: between 2% and 4%
- Kentucky: from 4% to 16%
- Maryland: 10%
- Nebraska: from 1% to 18%
- New Jersey: from 11% to 16%
- Pennsylvania: from 4.5% to 15%
In these states, it is usually necessary to file an inheritance tax return that lists the beneficiaries of the assets and the amount of tax due. Most states permit a portion of an inheritance to be tax-free, and an inheritance may be fully tax-free in certain situations. For instance, in New Jersey, inheritors are categorized based on their connection to the deceased.
Class A beneficiaries have no inheritance taxes. Close family members, including brothers, sons-in-law, and daughters-in-law, are considered Class C beneficiaries and excluded from paying taxes on the first $25,000 in inherited assets. Over $25,000 is subject to progressive taxation, with rates ranging from 11% to 16%.
How are Inheritance Taxes Calculated?
If inheritance taxes are due, they are only applied to the part of the inheritance that exceeds the exemption limit. After that point, taxes are often calculated based on a variable scale. Overall, rates start in the single digits and increase to from 16% to 18%.
For example, you might be responsible for paying taxes on $200,000 if you receive a $300,000 inheritance and your state levies an inheritance tax on over $100,000. Suppose there is a 10% tax rate. The inheritance tax due would be determined as follows:
- $200,000 x .10 = $20,000
So, the tax amount is $20,000. Remember that the exemption you receive and the rate you pay are primarily determined by your relationship to the dead. The closer your relationship to the deceased person, the higher the exemption and the lower the rate you will pay. In all 6 states listed above, survivors are exempt from inheritance tax. That also applies to domestic partners in New Jersey. Only Pennsylvania and Nebraska levy inheritance taxes on descendants.
How to avoid inheritance tax?
If you make advance plans, you can avoid subjecting your heirs to inheritance taxes by giving assets during your lifetime or putting property into a trust. If you have a huge estate to leave behind, having your heir relocate to a state without an inheritance tax may be something to consider. The recipient's residence determines the tax. In addition, the inheritance tax is typically avoided when assets are given to spouses and children.
One popular tactic is to purchase a life insurance policy in the amount you want to leave behind and designate the beneficiary as the person you want to leave the money to. There are no inheritance taxes associated with an insurance policy's death payout. Moreover, another option is to place assets under a trust, ideally an irreversible one. By doing this, you essentially eliminate them from your estate and their inheritance status after your passing. When you create the trust, you can schedule how the money will be distributed.
Estate Tax vs Inheritance tax
Estate taxes and inheritance taxes are two different types of taxes. The basis for both levies is the property's fair market value, often as of the death date. However, the estate is responsible for paying the estate tax, which is based on the decedent's estate worth.
On the other hand, the beneficiary is responsible for paying the inheritance tax, which is imposed on the value of any inheritance they receive. A single heir may not be affected by the difference between an inheritance tax and an estate tax with the same rates and exemptions. However, there are a few rare circumstances where inheritance may be liable to inheritance and estate taxes.
Do beneficiaries have to pay taxes on inheritance?
Beneficiaries may be required to pay taxes on their inheritance depending on their family link to the deceased and the state in which the decedent resided or owned property. These taxes may only apply to estates or real properties situated in one of the six states that charge inheritance taxes.
Inheritance taxes are never applied to surviving spouses. Depending on the state, other close relatives, such as the deceased's parents, siblings, and kids, are also excluded to a certain extent. Inheritance taxes mostly impact heirs who are unrelated or more distantly related.
Conclusion
In fact, no one wants to pay taxes on money they spent a lifetime to earn. But everyone has to follow state laws. Furthermore, they primarily apply to individuals who are not related to the deceased at all or to distant relatives. Inheritance tax is never payable by spouses, parents and children. One must consider estate-planning techniques such as irreversible trusts, insurance policies, and gifts to avoid these heavy inheritance taxes when considering inheritances that may be liable to taxes.
