Inheritance Tax Explained: What You Need to Know

What is Inheritance Tax?

Inheritance tax is a tax imposed on the value of an estate (property, money, and possessions) left to beneficiaries after one's death. In most cases where inheritance tax applies, the beneficiaries who receive the assets are responsible for paying the tax. This tax is distinct from federal or state estate taxes, which are taxed on the estate itself before assets are passed to heirs.

Difference Between Inheritance Tax vs Estate Tax

Here's a breakdown of the key differences between inheritance tax and estate tax:

Inheritance Tax

The beneficiary (the person receiving assets from the estate) is responsible for paying the inheritance tax based on the value of the assets each beneficiary receives. Tax rates may vary depending on the beneficiary's relationship to the deceased (e.g., spouse, child, or other relative). Only a few U.S. states have inheritance taxes: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Estate Tax

The deceased person's estate pays the tax before the remaining assets are distributed to the beneficiaries based on the total fair market value of the deceased person's estate after applying applicable deductions and exemptions. A federal estate tax with a high exemption threshold ($13.61 million for 2024) exists. Additionally, some states have their own estate tax laws, often with lower exemption limits.

Here's a simplified example to illustrate:

Imagine an estate valued at $2 million.

• Estate tax (federal and applicable states): If the federal or state exemption limit is exceeded, the estate itself will pay the estate tax before any money is distributed to the beneficiaries.
• Inheritance tax (in applicable states): Each beneficiary would pay taxes based on the portion of the $2 million they inherit. The applicable tax rates and exemptions would depend on their relationship to the deceased and their state laws.

Key Points to Remember

• Location matters: The presence of estate tax and/or inheritance tax depends entirely on the laws of the state where the deceased person resided.
• Exemption thresholds: Exemption amounts for estate and inheritance tax can significantly impact whether or not any taxes are due.
• Financial impact: Depending on the size of the estate and applicable laws, understanding the difference between the two taxes is key for estate planning and protecting inheritance for beneficiaries.

1. Take Advantage of Exemptions

• Annual Gift Tax Exclusion: Each year, you can gift assets up to a certain amount ($17,000 in 2023) to individuals without incurring gift tax or impacting your lifetime estate tax exemption. Over time, this can significantly reduce your taxable estate.
• State-Specific Exemptions: If your state has an inheritance tax, it likely has exemptions. Gifting assets or leaving portions of your estate to qualify for those exemptions reduces your taxable base.

2. Establish Trusts

Trusts can help in several ways:

• Irrevocable Trusts: With an irrevocable trust, you transfer ownership of assets to the trust, removing them from your taxable estate. The assets grow within the trust, and distributions to beneficiaries can be structured to minimize taxes.
• Charitable Trusts: Assets placed in a charitable trust qualify for tax deductions. Various types of charitable trusts (e.g., Charitable Remainder Trusts) can provide income benefits while eventually benefiting a chosen charity.

3. Make Charitable Donations

• During your lifetime: Charitable giving can be deducted from your taxable income, which can help to lower your overall tax bill. 
• Bequests in your will: Leave a portion of your estate to qualified charities, and your estate will receive a deduction, decreasing its taxable value.

4. Utilize Life Insurance

• Life Insurance Trusts: Creating an Irrevocable Life Insurance Trust allows the trust to own the life insurance policy, removing the death benefit proceeds from your taxable estate. These funds can be used to cover inheritance tax bills for beneficiaries.

5. Consider "Spousal Exemption" (if applicable)

• Unlimited Transfers: In most cases, assets left to a surviving spouse are exempt from inheritance or estate taxes. Strategizing for a larger spousal inheritance can minimize overall tax liability.

Important Notes:

• Professional Guidance is Essential: Estate planning and tax laws are complex. Consult with a financial advisor and an estate planning attorney to devise a personalized strategy that best suits your circumstances.
• State Laws: Inheritance tax rules vary significantly between states. Make sure the strategies you choose are appropriate for your state of residence.

Why Should Families Plan for Inheritance Tax?

Families should plan for inheritance tax for several crucial reasons, each aiming to help secure financial stability and ensure the intended distribution of assets to beneficiaries. Here's why planning for inheritance tax is essential:

Maximize Inheritance for Beneficiaries

The primary reason for planning is to maximize the inheritance passed on to beneficiaries. Without proper planning, a significant portion of an individual's estate could go towards paying inheritance tax, reducing the amount available for heirs. Strategic planning can minimize the tax on inheritances and ensure that more of the estate goes to loved ones.

Ensure Efficient Wealth Transfer

Effective inheritance tax planning facilitates a smoother and more efficient transfer of wealth to the next generation. Families can avoid complicated probate processes by setting up trusts, making gifts within allowable exemptions, and leveraging other tax planning strategies to ensure assets are distributed according to their wishes.

Avoid Unnecessary Financial Stress

The death of a loved one is already a stressful time, and the added financial burden of a large inheritance tax bill can exacerbate this stress. Planning can help avoid this scenario, ensuring families are not forced to sell cherished assets or property to cover tax liabilities.

Control Over Asset Distribution

Inheritance tax planning gives individuals greater control over how and when their assets are distributed. For example, by using trusts, individuals can specify conditions for asset distribution, such as releasing funds when a beneficiary reaches a certain age or for specific purposes like education or home buying.

Take Advantage of Allowances and Reliefs

Many jurisdictions offer allowances, exemptions, and reliefs that can significantly reduce inheritance tax liability. Planning allows families to use these benefits, which might include gift allowances, spousal exemptions, business relief, and more.

Preserve Family Businesses and Legacies

For families with business interests, inheritance tax planning is crucial for business continuity across generations. Strategies like business relief can protect family businesses from being sold off to pay inheritance taxes, preserving the family legacy and the livelihoods of those it employs.

Charitable Giving

Planning for inheritance tax can also involve charitable giving, which reduces the taxable estate and supports charitable causes meaningful to the individual. Donations to charity are often exempt from inheritance tax, offering a way to leave a lasting legacy beyond the immediate family.

Legal Compliance and Minimizing Disputes

Proper planning helps ensure compliance with tax laws and regulations, minimizing the risk of disputes with tax authorities. It also reduces the likelihood of conflicts among beneficiaries by clearly outlining the distribution of assets, guided by the individual's expressed wishes.

Conclusion

Planning for inheritance tax is a proactive measure that protects a family's financial interests, ensures the intended distribution of assets, and maintains harmony among family members during a challenging time.

Consulting with a financial planner or estate planning attorney can provide tailored advice and strategies to meet specific family needs and goals.

Sources

1. Does Your State Have an Estate or Inheritance Tax? Tax Foundation. https://taxfoundation.org/data/all/state/state-estate-tax-inheritance-tax-2023/.
2. Inheritance Tax. Cornell Law School - Legal Information Institute. https://www.law.cornell.edu/wex/inheritance_tax
3. Estate Tax. Internal Revenue Service (IRS). https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax