How Does Inheritance Tax Work?

How Does Inheritance Tax Work?

Posted by on Mar 22, 2022


When people use the term "inheritance tax," they generally refer to a levy against money or property that a person or entity inherits from someone who gives it to them in a will. However, there is sometimes confusion between an inheritance tax and the federal estate tax, which is different. In fact, there is no federal inheritance tax, although there is an estate tax. The IRS defines the estate tax as:

“…a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death. The fair market value of these items is used, not necessarily what you paid for them or what their values were when you acquired them. The total of all of these items is your "Gross Estate." The includible property may consist of cash and securities, real estate, insurance, trusts, annuities, business interests, and other assets.”

Currently, six states impose an inheritance tax, and twelve have an estate tax (only Maryland has both). The notable difference between the two types of assessment is who pays the tax and how they work. The beneficiary of the gift is responsible for paying any owed inheritance tax, while the estate pays the estate tax. The determination of estate taxes due is calculated before distributing assets to the named beneficiaries.

How Does an Inheritance Tax Work?

Each of the six states that impose a tax on inheritances has different rules. Each levies different percentages, and in most cases, the amount the beneficiary pays varies according to their relationship to the decedent. All six have an exemption for spouses, and in many cases, children are also exempt from the tax.

In most cases, the states have chosen to apply a broad range of exemption amounts and rates for different recipient categories. In Nebraska, for example, a close relative (parents, grandparents, siblings, children, and other lineal descendants) has an exemption for the first $40,000 and pay a one percent rate after that while unrelated recipients only have a $10,000 exemption and then pay a levy of 18%. Similarly, Iowa has five beneficiary categories while Kentucky has three.

Can You Avoid Inheritance Taxes?

If you live in one of the states that have an inheritance tax (and the list can change; Iowa is in the process of phasing its levy out during the next three years), there are some steps you can take to reduce or eliminate the impact of inheritance taxes on your heirs. One of the simplest is to start giving the money to the beneficiaries while you are living. For example, you can give someone up to $16,000 annually ($32,000 from a married couple) without triggering the gift tax, and that will reduce the amount that could be taxed if you include it as a bequest in your will.

Another way to sidestep the inheritance tax is to put the designated assets into a trust for the person you intend to distribute them to. Of course, trusts are complex, so talk to your financial advisor.

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.

Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.

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