Differences Between the Estate Tax and an Inheritance Tax

Not all "death taxes" are the same

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What differentiates between an estate tax and an inheritance tax? The most significant difference is who pays it. While the terms "estate tax" and "inheritance tax" are often used interchangeably when referring to taxes collected when someone dies, these two terms refer to two completely different types of death taxes.

Twelve states and the District of Columbia collect an estate tax at the state level as of 2018. Indiana had an estate tax but it was repealed in 2013, and Tennessee followed suit in 2016, repealing its estate tax as well. New Jersey and Delaware eliminated their estate taxes as of 2018.

The federal government also imposes an estate tax, although it does not have an inheritance tax. Only six states collect inheritance taxes and one of them—Maryland—collects both an estate and an inheritance tax.

What Is an Estate Tax?

An estate tax is calculated based on the net value of property owned by a decedent as of the date of her death. The estate's liabilities are subtracted from the overall value of her property to arrive at her net taxable estate.

All the jurisdictions that currently collect a state estate tax offer exemptions, and they can vary. Only the net value of an estate exceeding the amount of this exemption is taxed, and the tax comes off the top of the estate before bequests can be made to beneficiaries from anything that remains.

As for the federal estate tax, the exemption at that level is $11.18 million as of 2018, so very few estates find themselves liable for it.

What Is an Inheritance Tax?

An inheritance tax is calculated based on who receives a deceased person's property. Beneficiaries are liable for paying this tax, although a will sometimes provides that the estate should pick up this tab as well.

Transfers to surviving spouses are completely exempt from the inheritance tax in all six states that collect it. Four states—Iowa, Kentucky, Maryland, and New Jersey—also exempt transfers to surviving children and grandchildren, but property passing to children and grandchildren is subject to the state inheritance tax in Nebraska and Pennsylvania. More collateral heirs, such as brothers, sisters, nieces, and nephews, or friends, must typically pay this tax.

An Example of a Taxable Estate and Gifts

Let's say John Doe dies owning assets valued at $5 million. His liabilities, including any mortgages he held and other debts, total $2 million at the time of his death. His net estate is therefore $3 million for estate tax purposes.

At $3 million, John's estate would not be liable for the federal estate tax; it's well under the $11.18 million exemption threshold. But we'll say that his state's exemption is only $1 million. The balance over this amount—$2 million—would be taxed at the applicable rate.

For purposes of this hypothetical example, let's say that John's state levies an estate tax of 15 percent. His estate would therefore owe the state $300,000 before any bequests can be made from the remaining $1.7 million balance.

John also left his best friend a home valued at $500,000. John's state collects an inheritance tax of 15 percent from nonrelatives. His friend is not a close relation, and she's therefore liable for the inheritance tax on this amount. She would owe the state $75,000 for her receipt of the house, assuming John's will didn't indicate that his estate would pay for this.

The Bottom Line on Estate Taxes and Inheritance Taxes

Although someone who lives in a state that collects an inheritance tax might choose his individual beneficiaries carefully so as to avoid their incurring of a state inheritance tax, excluding brothers, sisters, nieces, nephews and friends, this option isn't possible in a state that collects a state estate tax.

Consider consulting with a local estate planning attorney about the best way to protect your assets under your state's tax laws.

NOTE: State laws change frequently and the preceding information may not reflect recent changes in the laws. For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.