We hear quite a bit about death and taxes and how they are largely unavoidable. Income taxes might be unavoidable, but some forms of tax, like the federal estate tax, can be avoided to a certain degree through the use of certain estate planning vehicles. One tax that does not get talked about very much is the inheritance tax.
Is Inheritance Tax the Same as Estate Tax?
Actually, an inheritance tax is quite different and presents different issues for people planning their estates and the people they intend to benefit.
An estate tax is a tax imposed, usually by the federal government or the state government, upon the assets owned by a person when that person dies. Grave robbery? In a sense, it is. The government adds up all of the assets a person owns and then taxes those assets if they exceed a certain amount. But, the tax is on the deceased person’s assets.
An inheritance tax is quite different. An inheritance tax is a tax on the recipient of a deceased person’s assets. The person inheriting money or property has to pay the tax on the assets that the person received.
Most states do not have an inheritance tax. In addition, among those states that do have an inheritance tax, the implementation of the tax varies quite a bit. States with some form of inheritance taxes are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. The form an inheritance tax takes and the amount of tax collected can vary based upon the relationship of the person inheriting to the person who died. Some states with inheritance taxes will exempt certain takers, such as a surviving spouse, from paying an inheritance tax or the rate of tax will vary based upon the relationship between the deceased person and the person receiving an inheritance. Unfortunately, because state law varies so widely, each state’s law must be consulted to determine the appropriate application of the tax.
Keep in mind that the inheritance tax applies only if the state where the deceased person lived had an inheritance tax or if the deceased person owned real estate in a state with an inheritance tax, in which case the inheritance tax would apply to the real estate but not the rest of the deceased person’s estate. Luckily, there is generally no income tax to be paid on an inheritance, but people receiving certain asset distributions, such as distributions from an IRA or other deferred tax vehicle, may receive assets that have built-in income tax consequences.
Inheritance taxes are generally disfavored. Indiana, Louisiana, New Hampshire, Tennessee and Utah had inheritance taxes that have been abolished within the last fifteen years.
Example of Inheritance Tax Implications
When Bob dies, he is a single man from Pennsylvania who owns three rental properties worth $2 million dollars each. Under the federal estate tax system, his $6 million dollar estate has an exemption for the first $5,450,000 worth of Bob’s assets and he will pay tax on the remaining $550,000, so Bob’s estate will pay the federal government $220,000 in federal estate taxes. The remaining assets will be distributed to Bob’s children. Bob has one son and a sister who survive him. His will distributes his estate evenly between them. After liquidating all of his buildings, Bob’s after-tax estate is $5,780,000 which is to be split between Bob’s son and his sister. Under Pennsylvania law, Bob’s son will pay tax at a rate of 4.5% while his sister will pay tax at a rate of 12%, so Bob’s son receives $2,788,850 while his sister receives $2,543,200.
Planning for Estates With Inheritance Tax
When a person plans their estate, they need to take into account whether or not an inheritance tax will affect their estate distributions and make a determination as to whether or not they want to do something about it. From our example, if Bob really wanted his sister and his son to receive an equal net amount of assets, he should have divided the estate differently because of the disparate inheritance tax rates each gift was subject to. Likewise, it is easy to forget about the tax treatment of an out-of-state parcel of real estate. When making an estate plan, failing to take possible inheritance tax consequences into account can cost thousands of dollars!
Want More Information on Inheritance Tax?
- Nolo Press offers some helpful information about estate taxes.
- The Tax Policy Center offers a briefing to explain why and how inheritance tax is assessed.
- The State of Pennsylvania offers a detailed explanation for one of the larger states charging estate tax; remember the specifics will be different if you live in another state.
- EY provides a worldwide estate and inheritance tax guide to enable internationally positioned individuals to quickly identify the estate and inheritance tax rules, practices and approaches that have been adopted by 39 jurisdictions.