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YOUR GUIDE TO HOW INHERITANCE TAX WORKS

YOUR GUIDE TO HOW INHERITANCE TAX WORKS

 

Benjamin Franklin once famously said that nothing in this world is certain – bar death and taxes. While many tend to laugh on this, it is something that is inevitably true. More ironically so in this case, where tax law has combined both these “certainties” into a unique experience called the inheritance tax.

Basically, the property you leave behind when you die goes down to your children, family and friends, or even to charity. And also to the government in the form of taxes. Said property may be deceased to any one of inheritance, estate, or state and federal tax statutes, or in some cases a few or all of them.

One chief area of concern is the inheritance and estate tax, which are often mistaken as one and the same. In this article, we’ll what inheritance taxes are and how they differ from estate tax.

 

Estate Tax and Inheritance Tax – the Key Difference

The first thing you should know about these two taxes is that while they are used in context of a deceased person’s property and assets (and are often famously called “death tax”), they are in fact two very different kinds of taxes. The exact definition of these two taxes, however, differs from one country to another and even from one state to another, as some states levy the inheritance tax while others don’t. In the context of this article, the definitions and standards mentioned are accurate with US law in general, with some state-wide variations.

Estate tax refers to the tax deducted by the federal government after the debts of your estates have been cleared, your property has been liquidated (if required), the funeral expenses have been made and the relevant officials (like the executor) have been paid their dues. It is only after the estate tax has been paid that the heirs receive their share (from the leftover worth). Needless to say, this is a tax that is paid by the estate itself.

Inheritance tax, on the other hand, is paid by the beneficiaries once they have received their share in the deceased’s property. In contrast to estate taxes, which are levied by the federal government, inheritances taxes are levied by the state governments, and that too by only a few states in the country. This often puts residents in some states at a double disadvantage of having to pay both taxes.

That said, there are exemptions to payment, which tend to reduce the amount that you will have to pay as taxes.

 

ESTATE TAX VS. INHERITANCE TAX

ESTATE TAX VS. INHERITANCE TAX

 

When the question is of Estate and Inheritance Taxes, the best news is that in most cases, you will be exempted – only those with big estates will be feeling the heat of taxes. That being said, there are some exceptions to this rule, and your unique inheritance situation (be it in terms of the size of the estate, your relation to the deceased, or anything else) may change your tax bill dramatically.

 

Estate tax vs. inheritance tax:

While many people consider estate and inheritance taxes to be the same, they are in fact two very different kinds of taxes. They have certain very vital differences, chief among them being the fact that estate taxes are deducted from deceased’s estate, whereas inheritance taxes are paid by the beneficiary. Depending on the size and location of the estate and the relationship between the deceased and the beneficiary, both, neither or either one could work as an active factor.

 

ESTATE TAX

The Estate tax is levied on the property that gets transferred from the deceased. As already mentioned, most people are exempted from paying the estate tax, Thanks to the IRS exempting estates of less than $5.49 million from it. Added to that is the fact that the exemption is applied per individual, which means that if a married couple can enjoy an exemption of $10.98 million (double of the original).

Estates which exceed the aforementioned threshold have up to 40% of tax rate levied on them by the IRS. In this case, however, the IRS taxes the assets at the current fair market value of the estate, and not on the amount that the owner has originally paid to buy the estate.

According to Tax Foundation, a Washington DC-based think tank, estate taxes are collected by the District of Columbia and 14 other states. These states may have an exemption threshold that is lower than the IRS. For instance, the threshold in Massachusetts is around $1 million. That said, the estate tax that the owner will pay will be to the state government, and not to the IRS.

 

INHERITANCE TAX

Contrary to the Estate tax, the Inheritance Tax is levied on the beneficiary. According to a Tax Foundation analysis, this tax is currently levied by the states of New Jersey, Nebraska, Iowa, Pennsylvania, Kentucky, and Maryland currently levy this tax on those who receive inheritances.

Much like the estate tax, the Inheritance tax too has several exemptions. For instance, in most cases, the deceased’s partner and children are exempted from paying it.

That said, some people may be doubly disadvantaged as well. Some states such as New Jersey and Maryland levy both estate and inheritance taxes. In such cases, both the owner and the beneficiary and will have to pay taxes, and taxes will be paid to the state government as well as the IRS. The chances of this happening, however, still remain very slim. Estate taxes are generally paid only when the value of the estate is very high and/or the beneficiary is not directly related to the deceased.

 

Inheritance Taxes

Inheritance Taxes

What are inheritance taxes?

As the name itself implies, inheritance taxes are those taxes that an individual needs to pay on any property or money that they have inherited after the death of a loved one. Being a state tax (and not the same as the federal estate tax), payment of inheritance taxes is the responsibility of the beneficiary of the property, and not the former owner of the estate. As of 2017, only six states in the United States impose an inheritance tax. Even within those states, there are several rules and measures on the amount of inheritance tax that needs to be paid. In fact, some beneficiaries are even exempt from paying it.

Inheritance Tax vs. Estate Tax

While the two tax categories may sound similar, they are in fact very different. The basic difference between the estate and inheritance taxes is the fact that the party responsible for paying it is different. As mentioned already, the inheritance taxes are paid by the person who inherits the estate of the deceased. The estate tax, on the other hand, although levied on the total value of the money and property of a deceased person, is paid by the decedent’s prior to distributing it to the beneficiaries.

In case of estate tax, the total value of the assets need to exceed certain thresholds. While these thresholds change every year, they generally stand at around $1 million. Thanks to a threshold this high, very few i.e. less than 2 percent of all taxpayers actually have to encounter this tax.

How does inheritance tax work?

The inheritance tax is calculated the moment the estate’s executor divides the assets and distributes them to the beneficiaries. The tax amount, which is calculated separately for every listed beneficiary, subsequently requires every beneficiary to pay the tax. Every state has its own threshold and measurements. For instance, a state can charge a 5 percent tax on any inheritance which is larger than $2 million. Which means that if your family member or friend has left you $5 million in his or her will, you will be required to pay the tax for the additional $3 million, i.e. $150,000. Of course, you would be legally obliged to report this information on an inheritance tax form.

Which states have inheritance tax?

Inheritance tax is exclusively a state tax, and is currently levied by only six states. These are Kentucky, Iowa, New Jersey, Nebraska, Pennsylvania and Maryland. As mentioned earlier, every state has separate laws as regards inheritance tax, from as low as 1 percent to as high as 25 percent of the total value of the money and property that you have inherited.

What are the exemptions on inheritance tax?

Certain reductions and/or exemptions are granted on the payable inheritance tax, which depends upon the relationship between the beneficiary and the decedent. For instance, money and property that is inherited from a spouse is generally tax-exempt. Often, children and other dependents also qualify for tax exemption. However, only a specific a part of the inherited property may qualify in their case. High rates of inheritance tax is paid by beneficiaries who have a distant, indirect or no familial relationship with the decedent.

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