Estate Tax vs. Inheritance Tax: What’s the Difference?

Losing a loved one is a challenging time in anyone’s life. The last thing you want to do is incur excessive taxes and fees on the estate of your loved one. Unfortunately, there are federal and state taxes to handle if there’s an estate or property involved.

Understanding the difference between estate tax and inheritance tax will help you plan for the future and make the painful process go smoother, quicker, and without surprises when the time comes. Let’s look at estate tax and inheritance tax to find out the differences so you can understand what your role may be and how to manage it.

What Are Estate Taxes?

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After an individual passes away and has left assets for beneficiaries, the federal government levies an estate tax based on the estate’s value. This tax can include almost anything, including real property, but there are exemptions, like donating to a tax-exempt charity or a spouse who is a U.S. citizen. Before 2001, every state imposed an estate tax as the federal estate tax return gave a tax credit towards estate taxes paid at the state level, and states based their tax rates on that credit. However, in 2001, amendments to federal tax laws removed these credits and, consequently, most states rescinded their estate tax.

The taxes are only levied on estates over a specific value, $11.7 million individual and $23.4 million for married couples as of this writing. This value is generally set by first imposing a base tax, and then there will be a rate varying between 18 and 40% depending on how far you exceed the minimum value for taxation. Many states in the U.S. also levy a state estate tax alongside the one set at the federal level. States with a state estate tax are: 

  • Connecticut.
  • Washington.
  • Hawaii.
  • Illinois.
  • Maine.
  • Maryland.
  • Massachusetts.
  • New York.
  • Oregon.
  • Rhode Island.
  • Vermont.
  • Washington, D.C.

Each of these states has different thresholds as well as base rates and progressive rates. If you live in one of these states, make sure you research your state’s rates and what responsibilities may be involved.

What Are Inheritance Taxes?

While the decedent pays the estate tax, the inheritance tax is a tax imposed upon the beneficiaries. If you inherited property or other assets from someone who has passed away, you might be responsible for this tax. Not all states incorporate an inheritance tax. Here are the ones that do: 

  • Iowa.
  • Kentucky.
  • Maryland.
  • Nebraska.
  • New Jersey.
  • Pennsylvania.

Of those states, Maryland is the only state that uses both estate tax and inheritance tax. Also of note, where you live is irrelevant. You follow the tax law the decedent lived in when they passed. As a beneficiary, the amount of the inheritance tax you pay depends not only on the value of what you inherited but also on your relationship to the decedent. In some states, siblings, children, and the surviving spouse are exempt from the inheritance tax. Other states exempt the spouse and children but not the siblings.

Example of Estate Taxation vs. Inheritance Taxation

As stated above, the real difference between estate tax and inheritance tax is the party responsible for paying the tax. The decedent pays the estate tax out of proceeds from their estate, while the inheritor pays taxes on what they inherited. And again, the estate tax can be federal or state, while inheritance tax is only at the state level.

As an example of how some of this works, let’s presume John passed away with assets valued at $5.5 million. After payments, debts owed, other fees, and any other miscellaneous items were paid directly from the liquid assets of $500,000, leaving $5 million as the amount subject to taxation. The federal exemption threshold sits at $11.7 million for an individual, which John’s estate is well below, therefore exempting his estate from federal estate tax.

But, let’s say John lives in Oregon, where the estate tax exemption threshold is set at $1 million. So that would mean that John’s estate would be taxable for the amount above the threshold of $4 million in this case. There is a base tax of $50,000 and an additional rate of 10.25% or $410,000. So the total tax amount owed for John’s $5 million estate would be $460,000.

Now to illustrate the inheritance tax, let’s say John lives in Pennsylvania instead of Oregon. Pennsylvania calculates its inheritance tax based on the relationship of the inheritor to the deceased. Children and grandchildren under 21 and the surviving spouse are not taxed at all on the value of their inheritance. For grandchildren and children over the age of 21, the tax rate is 4.5%, siblings of the decedent will pay a 12% tax on their inheritance, and all other inheritors will pay a 15% tax, aside from any other exempt entities like charities.

For example, let’s go back to John, who has willed his entire estate to his brother. Again, the amount is below the federal threshold for the estate tax, and Pennsylvania does not impose estate tax so that no estate tax would be applied. John’s brother will have to pay a tax rate of 12% or $600,000 on the $5 million estate for inheritance tax.

Final Thoughts

It is far better for your heirs that you have a plan in place before it’s needed to ease the transition of your estate to them. Make sure you understand the state and federal laws regarding estate and inheritance tax or work with a financial planner that does, so you can plan accordingly, thereby minimizing the burden on your grieving heirs.

If you have a large estate, it is advisable to seek out a financial planner who is an expert in estate planning. That way, they know of and have worked around the various issues and hurdles that might come up and can help you plan accordingly. If you’d like to learn more about financial planning, reach out to the knowledgeable team at Pasquesi Sheppard. You can contact us via our secure online form or give us a call at 847-234-5000.