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Estate taxes and inheritance taxes can add to the sting of losing a loved one, but not everyone has to pay them. The difference between estate tax and inheritance tax is significant, and understanding how each one works may help you to plan ahead. After learning the basics, consider discussing the details with a financial or legal representative and your family.
Estate Tax vs. Inheritance Tax
These terms may sound like they refer to the same thing, but there are important distinctions between these taxes. The primary differences are who pays the tax and who receives the funds.
A deceased person's estate pays estate taxes, and the recipient might be the federal or state government. Beneficiaries pay inheritance taxes to state governments, although not all states have inheritance taxes.
What Are Estate Taxes?
An estate tax is a tax based on the net value of a deceased person's assets at the time of death. That includes:
- Property like real estate
- Financial accounts
- Other assets
Debts, such as a mortgage loan, can reduce an estate's value, and there may be other adjustments resulting from various situations.
The deceased person's estate is responsible for paying estate taxes before distributing assets to beneficiaries.
Federal estate tax rates start at 18% and increase to 40%, and state estate taxes vary by state. Many families don't have to pay estate tax. Here's some more information on how federal and state estate taxes work:
Federal estate tax: The IRS sets a threshold for taxable estates, and only estates above that value need to file estate tax returns. For 2023, if the decedent is a U.S. citizen or resident, a return is generally only required for estates worth more than $12.9 million. If your estate is smaller than that exemption threshold, you would not owe federal estate taxes, but potentially owe an inheritance tax.
State estate tax: Twelve states and the District of Columbia have estate taxes. Those states are Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington. Each state's exemption amount is different, ranging from $1 million to $9.1 million.
The guidelines described here cover many scenarios, but it can help to discuss your situation with a tax or legal professional.
What Are Inheritance Taxes?
An inheritance tax is a tax you pay on assets received from a deceased person's estate. Only six states currently impose inheritance taxes:
- New Jersey
An inheritance tax is the responsibility of those who receive assets after somebody dies, not the estate. The amount each person pays may vary depending on how much they receive. If you receive an inheritance, check with your state to learn about any requirements for paying inheritance taxes. Even in states with inheritance taxes, you might be able to receive assets without paying any tax.
Example of Estate Tax vs. Inheritance Tax
This fictional example may help you to better understand how estate and inheritance taxes work. Say Pat dies with $1 million in assets, and she owes $200,000 on a real estate loan. As a result, her net estate is $800,000 (you often subtract debts from the gross estate, but a tax or legal professional can help you understand your unique situation). All assets pass to Pat's lifelong friend, Jane.
- Estate tax: $800,000 is well below the IRS threshold of $12.9 million, so no federal estate tax is due in this case. Pat's state exemption amount is $3.5 million, so she does not have assets above that level.
- Inheritance tax: Pat lives in a state with an inheritance tax. That state charges 10% on transfers to individuals who are not relatives of the deceased person (or who are otherwise exempt from paying taxes). Therefore, Jane must pay $80,000. If Jane was Pat's daughter, the assets might pass without any inheritance tax, depending on state law.
Different Taxes for Different Situations
These tax types may both arise after somebody dies with assets. There is a big difference between estate tax and inheritance tax, and you might not have to pay taxes in some cases. Estate planning can help you predict what an estate owes, and can help beneficiaries plan for their futures. Consider speaking with a tax or legal professional for more information.