Differences Between the Estate Tax and an Inheritance Tax

Not all "death taxes" are the same

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The most significant difference between an estate tax and an inheritance tax is who is responsible for paying it. The terms are often used interchangeably when someone dies, but they're two different types of death taxes.

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

An inheritance tax is calculated based on the value of individual bequests received from a deceased person's estate. The beneficiaries are liable for paying this tax, although a will sometimes provides that the estate should pick up this tab as well.

How an Estate Tax Works

At one point, all states had an estate tax. The federal estate tax return offered a credit toward state-level estate taxes and states based their own tax rates on this federal credit. But that changed in 2001 when federal tax law amendments eliminated the credit. Many states repealed their estate taxes as a result.

Twelve states and the District of Columbia collect an estate tax at the state level as of 2019. Indiana, Ohio, and North Carolina had estate taxes, but they were repealed in 2013. Tennessee followed suit in 2016, and New Jersey and Delaware eliminated their estate taxes as of 2018. Oklahoma and Kansas have also repealed their estate taxes.

All states that collect an estate tax offer exemptions and the value of these exemptions can vary. Only the net value of an estate that exceeds the exemption amount 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, very few estates find themselves liable for it because the exemption at that level is $11.7 million as of 2021. Only estates valued at more than this are subject to the tax.

How an Inheritance Tax Works

The federal government doesn't have an inheritance tax, and only six states collect one. Maryland has the dubious distinction of being the only state to collect both an estate and an inheritance tax as of 2021.

The other five states with an inheritance tax are Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania. Indiana had one, but it's been repealed.

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 distant heirs, such as siblings, nieces, nephews, and friends, must typically pay this tax, and the tax rate tends to escalate as the degree of kinship decreases.

Most states offer exemptions for inheritance taxes as well. Only gifts above a certain value are taxed.

Example of a Taxable Estate

John Doe died owning assets valued at $5 million. His liabilities, including any mortgages he held and other debts, totaled $2 million at the time of his death. His net estate is, therefore, $3 million for estate tax purposes—the value of his assets less his liabilities.

John's estate would not be liable for the federal estate tax at $3 million because this is well below the $11.7 million federal exemption threshold. But his state's exemption is only $1 million. The balance over this amount—$2 million—would therefore be subject to a state-level estate tax.

Assuming his state's tax rate is 15%, John's estate would owe $300,000 before any bequests can be made: 15% of $2 million. The remaining $1.7 million balance would pass to his beneficiaries or heirs.

Example of a Taxable Bequest

John left his best friend a home valued at $500,000, and John's state also collects an inheritance tax of 15% from nonrelatives. His friend isn't a close relation, so 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 the tax.

The house was part of John's $3 million estate, so it's effectively taxed twice.

The Bottom Line

You might want to choose your beneficiaries carefully so as to avoid having them incur a state inheritance tax. This might mean excluding brothers, sisters, nieces, nephews, and friends, however. You can also provide that your estate will pay the inheritance tax, but this will leave less for your beneficiaries overall.

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.

Frequently Asked Questions (FAQs)

When is an estate tax return due?

Estate tax returns typically become due nine months after the death. If you can't file by the due date, you can request a six-month extension.

What is the estate tax exemption?

The estate tax exemption sets the threshold for when estate taxes begin to apply. In 2022, the estate tax exemption is $12.06 million. If someone dies in 2022 with an estate worth less than $12.06 million, then they will not owe any estate tax.

Article Sources

  1. Internal Revenue Service. "Estate Tax."

  2. Internal Revenue Service. "Filing Estate and Gift Tax Returns."