Estate taxes and inheritance taxes are often discussed as if they're the same thing, but in reality they are very different in concept and practice.
If you're worried about paying estate or inheritance taxes, take a deep breath. Not every estate will pay estate taxes, and not every heir will pay inheritance tax. So the first step is to determine whether these taxes impact you as a benefactor or inheritor.
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Here's what to know about the inheritance tax, how it differs from the estate tax and strategies for reducing it.
Is inheritance taxable?
Inheritance can be taxable to heirs, depending on the state in which the benefactor lived and the inheritors' relationship to the benefactor.
To find out whether you owe inheritance tax, you're going to have to review a few facts about your specific inheritance situation. If you're still confused, talk to your financial advisor, accountant or another financial professional to verify whether you should set aside money to pay inheritance taxes.
What is inheritance tax?
Inheritance tax is a state tax on a percentage of the value of a deceased person's estate that's paid by the inheritor of the estate. There is no federal inheritance tax.
Today, just six states charge inheritance tax, according to the American College of Trust and Estate Counsel. The states that levy inheritance tax are:
- New Jersey.
If you inherit property, cash, investments or other assets from that state or from a deceased friend or relative who lives one of these states, you'll likely need to file a state tax form. "If you don't file it on time, you should probably expect the state is going to look for penalties and interest," says Gerry Joyce, managing director and national head of trusts and estates at Fiduciary Trust Company International.
Inheritance tax laws and exemption amounts vary among the six states. In Pennsylvania, for example, no inheritance tax is charged to a surviving spouse, a son or daughter age 21 or younger and certain charitable and exempt organizations. After that, inheritance tax is charged on a tiered system. Direct descendants and lineal heirs pay 4.5%, siblings pay 12% and other heirs pay 15%.
Whether you pay inheritance tax is determined by the state in which the benefactor – your deceased friend or relative – lived, not where you live. For example, if you live in a no-inheritance-tax state, such as Virginia, but your great uncle who resided in Maryland leaves you his checking account balance, you could be on the hook for inheritance tax.
What is the estate tax?
Estate taxes are taken out of the deceased's estate after death and are not the responsibility of the heirs.
On the federal level, a 40% federal estate tax is levied on the portion of an estate exceeding $11.4 million in 2019 ($22.8 million for married taxpayers). So unless your relative is a multimillionaire, he or she won't have to worry about paying federal estate tax.
Some states also charge their own estate taxes on assets topping a certain value, according to consumer legal site Nolo. States that charge their own estate tax are:
- The District of Columbia.
- New York.
- Rhode Island.
States laws vary, with some providing exemptions up to the federal amount of $11.4 million and others charging tax on lower amounts.
Reducing estate taxes will be on the shoulders of the benefactor, who will need to work with his or her estate planning attorney to identify transferring, gifting or investment strategies that can mitigate or eliminate estate taxes for certain assets.
Inheritance tax vs. estate tax
While both these taxes can be considered scary-sounding "death taxes," it's important to note that they're different and don't impact everyone.
Inheritance taxes are state taxes. Remember that inheritance taxes are imposed by just six states and are the responsibility of the heirs of the estate, even if they live in another state. "If you have a relative who passes away in one of these states, you just have to know there could a tax bill due," Joyce says.
Estate taxes are federal and state taxes. The federal estate tax is a 40% tax on assets topping $11.4 million for 2019 ($22.8 million for married couples) and is charged no matter the state in which you live. Some states have additional estate taxes with their own rules and exemptions.
Inheritance taxes are paid by the heirs. If you inherit assets from a relative or friend living in an inheritance tax state, and you are not in an exempted group, you may owe taxes on the amount received. If you're looking for strategies to reduce or pay your taxes, work with a certified financial planner to identify next steps.
Estate taxes are paid by the estate. Those who think they'll have estate tax taken from their assets – typically only very high-net-worth individuals – will need to work with an estate planning attorney and financial planner to come up with ways to reduce taxes and transfer money efficiently.
Strategies to reduce inheritance taxes
Unfortunately for heirs, much of the responsibility for determining how to reduce the inheritance tax you'll pay is on the benefactor leaving you the money.
The choices your friend or relative makes in how she structures her estate and names heirs will have an impact on how much tax you'll owe in the year she dies. Once she passes away, those decisions are locked in, and you'll be on the hook if she died in an inheritance tax state. But there are a few strategies you can use to reduce your tax burden.
Talk to your relative or friend. It's always an awkward conversation, but if you can speak with a close friend or relative from whom you expect to receive an inheritance about their plans for transferring assets and any taxes you should anticipate, it can be helpful.
"We are very regularly speaking with our clients about making sure their parents have properly planned," says Jonathan Forster, partner at Weinstock Manion in Los Angeles.
There are myriad strategies benefactors can use while still living, such as making gifts and charitable contributions, to reduce inheritance taxes for their heirs. But those are largely up to your friend or relative, not you.
Prepare for the tax bill. Know that there could be tax-filing requirements on you when you receive taxable inherited assets or draw down certain accounts. Put money aside to pay the tax bill, so it doesn't catch you by surprise. Keep in mind that you may owe capital gains tax on assets that have appreciated in value or income tax on distributions from an inherited retirement account. Remember: If you don't pay owed inheritance taxes or pay them late, you'll owe penalties and interest.
Remember, too, that the inheritance tax laws, percentages and exemption amounts in the state in which your relative lives may change in the years before he or she passes away, so there's a certain degree of unpredictability.
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