All You Need To Know About Inheritance Tax
In and of itself, inheritance can be a complicated matter. Issues can arise about what the deceased has left behind, and to whom. Emotions can run high. Legalities often need to be ironed out.
And then there is the issue of inheritance tax. We answer some of the most pressing and common questions regarding inheritance tax so that you can gain a better understanding of what you’re getting into when it comes to inheritance.
What Exactly Is Inheritance Tax?
An inheritance tax is a state tax levied on the value of inherited assets and is paid by the inheritor rather than the estate of the deceased.
Surprisingly, inheritance tax is not common in the U.S. As of 2022, only six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The taxation depends on the state where the deceased lived or owned property, the inheritance value, the beneficiary’s relationship to the decedent, and the prevailing rules where you live.
Is There A Difference Between Inheritance Tax And Estate Tax?
Let’s be clear: An inheritance tax is not the same as an estate tax. An estate tax is assessed on the estate itself before its assets are distributed, whereas an inheritance tax may be imposed on the bequest’s beneficiaries.
While there is no federal inheritance tax in the U.S., the government taxes large estates directly by imposing estate taxes and possibly income tax on any earnings from the estate.
Must Beneficiaries Pay Taxes On Inheritance?
Whether or not beneficiaries pay inheritance taxes depends on their familial relationship to the deceased and the state where the decedent lived or owned property. Surviving spouses are exempt from inheritance taxes in all six states, and domestic partners are exempt in New Jersey. Other immediate relatives, including the deceased’s children, parents, and siblings, are exempt from taxes to varying degrees, depending on state rules. Descendants are only subject to an inheritance tax in Nebraska and Pennsylvania.
Some individuals may be entitled to inherit a certain sum without taxes being levied or they may be eligible to pay a lower tax rate on the remaining sum. It’s fair to say that inheritance taxes pertain more to distant relatives and unrelated heirs than close family members.
How Is Inheritance Tax Calculated?
An inheritance tax is applied only to the portion of an inheritance that exceeds an exemption amount. Tax is usually assessed on a sliding basis, and rates begin in the single digits and increase to between 15% and 18%, on average.
As a general rule, the closer your familial relationship to the deceased, the higher the exemption and the lower the rate you’ll be required to pay. Most states recognize three classes of beneficiaries depending on their family relationship to the deceased: immediate, lineal, and unrelated. Tax rates and exemptions are based on those categories.
Is It Possible To Avoid Inheritance Tax?
Residents with significant assets and who live in a state that imposes inheritance tax may want to take measures to minimize their heirs’ tax exposure.
• Purchase A Life Insurance Policy
The death benefit from an insurance policy isn’t usually subject to inheritance taxes. You may want to consider buying a life insurance policy in the sum you wish to bequeath and name the person you want to leave it to as the policy beneficiary. The bequeathed sum, however, could be subject to an estate tax if the estate or revocable trust was named as the beneficiary of the policy.
• Place Assets In A Trust
Putting assets in a trust, preferably an irrevocable trust, is another option that may help avoid the levying of inheritance tax. By setting up a trust, you effectively remove assets from your estate, thereby avoiding their classification as an inheritance upon your death. When you establish a trust, you can specify a schedule for the distribution of the funds. It’s important to note that establishing a trust can be complicated and requires careful wording to ensure compliance with state tax laws. Working closely with a trust and estates attorney is advised when you’re establishing this type of legal document.