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What is an Inheritance Tax?

definition

An inheritance tax is a levy that some states charge against the gift someone inherits from the estate of the deceased.

🤔 Understanding inheritance tax

An inheritance tax is a fee some states charge for the gift a person receives from the estate of a deceased person. As of 2019, six states collect inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Each state that collects inheritance taxes has its own tax rates and exemptions. There’s no federal inheritance tax in the United States because the Internal Revenue Service does not classify a gift from the decedent’s estate as income. However, some estates are subject to a separate estate tax.

example

Suppose Uncle Horatio dies and generously leaves money for each of his favorite relatives. He leaves $3M to his son, $2M to his niece, and $1M to his cousin. If Uncle Horatio lived in a state that collects inheritance tax, the relatives would each have to pay a percentage of the gift amount according to that state’s sliding scale. States usually set the tax rate based upon the inheritance amount and the closeness of the family connection. That means each of Horatio’s relatives will face different circumstances governing inheritance tax.

Takeaway

An inheritance tax is like the price you have to pay to receive a “free” download from the internet...

A company may be willing to give you their e-book for free, but there’s one small string attached — You have to give the company your email address. Similarly, you’re welcome to keep the inheritance you received from your late Aunt Hildegarde as long as you pay the tax authorities what they require.
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What is an inheritance tax?
How does inheritance tax work?
How much money can you inherit before you have to pay inheritance tax?
Inheritance tax and estate tax: key differences explained
Limiting your potential inheritance tax

What is an inheritance tax?

Inheritance tax is the fee some states charge for inheriting a gift from a deceased person’s estate. It’s sometimes referred to as a type of “death tax.” Not everyone who inherits valuables has to pay. Only people who receive property from a decedent who lived in a state with inheritance tax laws are likely to have to pay.

As of 2019, the only six states with inheritance taxes are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. In other words, if your benefactor didn’t live in one of those states or own property there, you probably aren’t subject to an inheritance tax.

How does inheritance tax work?

States that levy inheritance taxes take into consideration two key factors.

Value of the gift: Typically, states use the market value of the decedent’s estate at the time of death to help calculate the tax bill. However, sometimes the dollar amount of the property is based upon the market value six months after the benefactor’s death.

Relationship of the benefactor and the inheritor: Usually, family members closely related to the decedent pay less in taxes than more distant relatives. For example, spouses are traditionally exempt from inheritance taxes. Siblings may have to pay a relatively small inheritance tax compared to what cousins would have to pay.

How much money can you inherit before you have to pay inheritance tax?

How large of an inheritance you can receive before the authorities ask you to pay an inheritance tax depends on state law. Let’s look at each state’s exemption amount as well as their tax rates. Always verify the information to stay abreast of any changes.

Iowa

Exemptions: There’s no inheritance tax if the estate’s value is less than $25,000. If it exceeds this threshold, there are still exemptions for certain relatives, including surviving spouses, the decedent’s parents, grandparents, great-grandparents, or other lineal ascendants. Lineal descendants such as children, stepchildren, grandchildren, and great-grandchildren are also tax-exempt in Iowa.

Close relatives: Brothers, sisters, half-brothers, half-sisters, sons-in-law, and daughters-in-law must pay anywhere from 5% to 10% of the gift’s value. The tax is 5% if the property’s value is less than $12,500. If the value is over $150,000, the tax is $11,375 plus 10% of the amount over $150,000.

Distant relatives and others: Uncles, aunts, nephews, nieces, foster children, cousins, brothers-in-law, sisters-in-law, and other individuals must pay taxes between 10% and 15% of the value of their inherited items. If the value is less than $50,000, the tax is 10%. Between $50,000 and $100,000 the rate is $5,00 plus 12% of the amount above $50,000. When the value goes beyond $100,000, the tax is $11,000 plus 15% of the amount over $100,000.

Kentucky

Exemptions: The state doesn’t impose a tax on gifts of $1,000 or less. Exemptions on inheritances with a higher value extend to surviving spouses, parents, children, and grandchildren. Also exempt are the decedent’s brothers and sisters as well as half-brothers and half-sisters.

Close relatives: When a gift’s value exceeds $1,000, a tax of 4% to 16% is due from great-grandchildren, sons-in-law, and daughters-in-law. The same rate applies to uncles, aunts, nephews, nieces, half-nephews, and half-nieces.

Distant relatives and others: The first $500 is exempt. The tax rate for a property with a value of over $500 is 6% to 16% for distant relatives.

Maryland

Exemptions: Maryland exempts surviving spouses, parents, stepparents, grandparents, children, and grandchildren. There’s also no inheritance tax for spouses of lineal descendants such as sons-in-law and daughters-in-law. Corporations can avoid paying taxes if state-specified relatives of the deceased are stockholders of that corporation. Maryland recognizes domestic partners by exempting them from inheritance tax on the couple’s primary residence.

Close relatives: Unless otherwise specified, Maryland charges non-exempt relatives a tax of 10%.

Distant relatives and others: Distant relatives and others can expect to pay 10% in inheritance tax.

Nebraska

Exemptions: Surviving spouses don’t pay inheritance taxes.

Close relatives: Brothers, sisters, children, and other lineal descendants may not have to pay tax on the first $40,000 of the gift. If the property has a value greater than $40,000, the recipient pays a 1% tax on the amount above that threshold.

Distant relatives and others: Cousins of the deceased can receive an exemption on the first $15,000 of the property. Inheritors who are not related to the decedent pay 18% for property worth more than $10,000.

New Jersey

Exemptions: The state exempts surviving spouses as well as civil union and domestic partners. Parents, grandparents, children, stepchildren, grandchildren, and any other lineal descendants also receive an exemption. Additionally, the state allows children mutually-acknowledged in a domestic partner relationship to inherit tax-free property.

Close relatives: Inheritances of up to $25,000 carry no tax liability for the deceased’s brothers and sisters, half-brothers and half-sisters, sons-in-law and daughters-in-law, or the civil union partners of the decedent’s children. The exemption also applies to the surviving spouses of the decedent’s deceased children. The first $1.075M over $25,000 comes with a tax of 11%. The next $300,000 has a tax of 13%. The rate moves to 14% for the $300,000 after that. The state charges 16% on any property with a value greater than $1.7M.

Distant relatives and others: The initial $700,000 of a gift triggers a 15% tax rate. A fee of 16% applies to amounts over $700,000.

Pennsylvania

Exemptions: Surviving spouses and children 21 or younger are exempt from inheritance taxes.

Close relatives: Children and other lineal descendants face a tax of 4.5%. The siblings of the deceased must pay a 12% tax.

Distant relatives and others: The state charges distant relatives and non-relatives a 15% fee.

Inheritance tax and estate tax: key differences explained

Inheritance tax and estate tax are not the same. Taxpayers tend to confuse the two, but a brief examination quickly shows the difference between them. Let’s look at three identifying characteristics.

Level of government imposing the tax: Inheritance tax is only at the state level. It’s not a tax from the federal government. In contrast, estate taxes exist at both the state and federal levels. As of 2019, the IRS charges 40% on estates with a value of over $11.4M, or $22.8M for married couples. However, the IRS doesn’t consider an inheritance as income for the inheritor, so there’s no federal income tax and no need to list it on your federal tax return.

Location: The federal estate tax rate doesn’t change according to where people live. However, inheritance tax does differ based upon location. An inheritance tax might come into play if the deceased person lived in a state that collects inheritance tax or owned property there.

Who pays the tax: Estate tax is the responsibility of the estate to pay before disbursements are made to the beneficiaries. The bill for inheritance tax goes to the receiver of the gift from the estate.

Limiting your potential inheritance tax

Professional financial planners can give you steps to reduce your likelihood of paying tax on assets given to you. One simple strategy involves gift giving. Gifts are tax-free in many states. Do your research to determine your state’s policy.

If you live in one of the many states without a gift tax and want to take advantage of the situation, talk to your benefactor. The key is for your benefactor to give you your gift while still alive rather than to bequeath it to you in a will.

The IRS allows you to receive up to $15,000 annually tax-free and up to $11.58M during the benefactor’s lifetime. And if your relative or friend stays within the IRS guidelines, they won’t have to file a return to report the gift.

The gift doesn’t have to be in the form of checks or cash. You can receive a variety of assets including homes, land, and securities.

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