What Is Inheritance Tax?
An inheritance tax is a tax imposed by certain states on those who are bequeathed or receive assets from the estate of a deceased person. on the state in which the decedent lived or owned property, the value of the inheritance, and the beneficiary's relationship to the decedent.
Inheritance tax is known in some countries as a "death duty" and is occasionally called "the last twist of the taxman's knife."
- Inheritance tax is a levy on assets inherited from a deceased person.
- Unlike estate tax, which is levied on the value—and comes out—of the decedent's estate, an inheritance tax is levied on the value of the inheritance received by the beneficiary, and it is the beneficiary who pays it.
- There's is no federal inheritance tax, but inherited assets are taxed on residents of six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
- Whether you will pay inheritance tax depends on the amount of the inheritance and your relationship to the deceased—with lower values and closer relatives being less likely to be subject to tax.
- Inheritance taxes can be minimized or avoided by leaving heirs money via trusts or insurance policies, or by gifting sums during one's lifetime.
Understanding Inheritance Taxes
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, while an inheritance tax is imposed on a beneficiary when they receive assets.
In the U.S., there is no federal inheritance tax. While the U.S. government taxes large estates directly—imposing estate taxes and if relevant, income tax on any earnings from the deceased estate—it does not impose an inheritance tax on those who receive assets from an estate.
In the U.S., inheritance taxes are strictly a state levy. Six states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) impose inheritance taxes. Whether your inheritance will be taxed, and at what rate, depends on its value, your relationship to the person who passed away, and the prevailing rules where you live.
Inheritance tax is assessed by the state(s) where the decedent lived or owned property.
How Inheritance Taxes Are Calculated
An inheritance tax, if due, is applied only to the sum that exceeds an exemption amount. Above those thresholds, tax is usually assessed on a sliding basis. Rates typically begin in the single digits and rise to between 15% and 18%. Both the exemption you receive and the rate you're charged may vary by your relationship to the deceased—more so than with the value of assets you are inheriting.
As a rule, the closer your relationship to the decedent, the higher the exemption and the lower the rate you'll pay. Surviving spouses are exempt from inheritance tax in all six states. Domestic partners, too, are exempt in New Jersey. Descendants pay no inheritance tax except in Nebraska and Pennsylvania.
Life insurance payable to a named beneficiary is not typically subject to an inheritance tax. It may be subject to an estate tax if the estate or a revocable trust was the beneficiary of the policy.
Inheritance Tax Thresholds
In most states, an inheritance tax applies to bequests above a certain amount, In a few instances, the size of the estate is significant. For example:
- In Iowa, if the estate is valued at less than $25,000 then no tax is due when property passes to the recipients.
- In Maryland, inheritances from estates smaller than $50,000 are also exempt.
There are further exemptions for heirs, depending on how close the person was to the deceased. Here are the threshold minimums and beneficiaries on which inheritance tax may be imposed.
- Iowa: Immediate family (spouses, parents, children) are exempt; charities exempt up to $500. The tax rate on others ranges from 5% to 15% of inheritance.
- Kentucky: Immediate family (spouses, parents, children, siblings) exempt; other recipients exempt up to $500-$1,000. The tax is on a sliding scale based on the size of inheritance and includes a minimum amount, plus a percentage ranging from 4% to 16%.
- Maryland: Immediate family (parents, grandparents, spouses, children, grandchildren, siblings) and charities exempt; other recipients exempt up to $1,000. The tax rate is 10%.
- Nebraska: Spouses and charities fully exempt; immediate family (parents, grandparents, siblings, children, grandchildren) exempt up to $40,000. exempt up to $15,000 all others, up to $10,000. Tax rate is 1%, 13%, or 18%.
- New Jersey: Immediate family (spouse, children, parents, grandparents, grandchildren) and charitable organizations exempt. Siblings and son/daughter-in-laws exempt up to $25,000. The tax rate ranges from 11% to 16%, depending on the size of inheritance and relationship.
- Pennsylvania: Spouse and minor children exempt. Adult children, grandparents, and parents exempt up to $3,500. The tax rate is 4.5%, 12%, or 15%, depending on relationship.
Inheritance Tax vs. Estate Tax
Inheritance taxes and estate taxes are often lumped together as "death taxes." However, they are two distinct forms of taxation.
Both levies are based on the fair market value of a deceased person's property, usually as of the date of death. But an estate tax is levied on the value—and comes out—of the decedent's estate. In contrast, an inheritance tax is levied on the value of the inheritance received by the beneficiary, and it is the beneficiary who pays it.
Of course, if you were the sole beneficiary of an estate, that might seem like the same thing—the amount the estate is worth, and the amount you inherit. But technically, they are subject to different taxes. And in some situations, an inheritance could be subject to both estate and inheritance taxes.
According to the Internal Revenue Service (IRS), the federal estate tax is only applied to estates with values exceeding $11.58 million in 2020 and 11.70 million in 2021. If the estate passes to the spouse of the deceased person, no estate tax is assessed.
If a person inherits an estate that is large enough to trigger the federal estate tax, and the decedent lived or owned property in a state with an inheritance tax, the beneficiary faces both taxes. The estate is taxed before it is distributed, and the inheritance is then taxed at the state level.
They may also face a state estate tax. As of 2021, a dozen states and one district still have these levies: Connecticut, District of Columbia, Hawaii, Illinois, Maine, Massachusetts, Maryland, New York, Oregon, Minnesota, Rhode Island, Vermont, and Washington State.
Maryland is currently the only state that imposes both an estate tax and an inheritance tax.
If you live in a state that has an estate tax, you're more likely to feel its pinch than you are to pay federal estate tax. The exemptions for state and district estate taxes are all less than half those of the federal assessment. Some go as low, relatively speaking, as $1,000,000.
Avoiding Inheritance Tax
While a lot of exceptions and exemptions to inheritance tax exist, especially for spouses and children, there still may be a desire to avoid or minimize them, especially if you have significant assets to leave. Basically, strategies to do so involve getting the assets out of your estate or stretching out their distribution. Some common ones include:
Buy a life insurance policy in the sum you wish to bequeath and make the person you want to leave it to the beneficiary of the policy. The death benefit from an insurance policy is not subject to inheritance taxes.
Put assets in a trust—preferably an irrevocable trust. This effectively removes them from your estate and their classification as an inheritance upon your death. You can set up a schedule for the distribution of the funds when you establish the trust.
Trusts are complicated animals and must be set up and worded carefully and meticulously to comply with state tax laws. So don't try doing so without a trust and estates attorney's help.
Consider giving money gradually, while you're alive, to recipients—instead of a lump-sum bequest upon your death. States usually don't tax gifts.
How Much Can You Inherit Without Paying Taxes?
The amount you can inherit without paying income taxes is infinite. There's no income tax due to beneficiaries on the sums they inherit.
In terms of inheritance taxes, the amount of tax due varies by the state, the size of the inheritance, and the relationship of the heir to the deceased. In the six states that impose an inheritance tax, the rates range from 1% to 18% of the bequest.
What Is the Federal Inheritance Tax Rate?
Strictly speaking, it is 0%. There is no federal inheritance tax—that is, a tax on the sum of assets an individual receives from a deceased person.
However, the Internal Revenue Service (IRS) can impose a tax on all the assets a deceased person leaves behind them, known as their estate. For 2021, this estate tax applies to estates greater than $11.7 million. The tax is assessed only on the portion of an estate that exceeds this amount. The rate is on a sliding scale, from 18% to 40%, along with a flat sum.
Do Beneficiaries Have to Pay Taxes on Inheritance?
It depends on who they are and where the decedent lived or owned property. Only estates or property located in one of six states that impose inheritance taxes are subject to inheritance taxes.
Surviving spouses are always exempt from inheritance taxes. Other immediate relatives, like the deceased's parents, children, and siblings, are exempt to varying degrees, depending on the state. They may be allowed to inherit up to a certain sum tax-free or pay at differing rates.
Inheritance taxes mainly affect more distant family members or unrelated heirs.
How Is Inherited Tax Calculated?
Inheritance tax calculations vary by state. Most states divide beneficiaries into different classes, depending on the closeness of their relationship to the deceased (immediate, lineal, unrelated), and set exemptions and tax rates based on this class.
Most states only apply tax to an inheritance above a certain amount. They then charge a percentage of this sum; it may be flat or it may be graduated. Kentucky, for example, imposes a rate that ranges from 4% to 16%, rising as the inheritance amount does, from $1,000 to over $200,000. It also imposes a flat dollar figure, ranging from $30 to $28,670, based on the sum inherited.
The Bottom Line
Inheritance taxes only affect residents in six states. And they mainly apply to distant relatives or those completely unrelated to the deceased. Spouses are always exempted, and immediate family members—children, parents—often are as well. Siblings, grandchildren, and grandparents, if they're taxed at all, have more generous terms (larger exemptions, lower rates).
Still, inheritance taxes can kick in at relatively small amounts—sometimes as little as $500. So those wanting to make bequests to people vulnerable to inheritance might consider some estate-planning strategies to spare them "the last twist of the taxman's knife."