Inheritance Tax: What It Is And How It Works

Inheritance Tax words on a tablet

In 2022 alone, the IRS collected an estimated $33 billion in revenue from inheritance tax. So, what is inheritance tax? And why should it be a critical consideration for people who are estate planning? Realized 1031 has shared a comprehensive guide about inheritance tax and everything you should know about it.

What Is Inheritance Tax?

For those who are new to estate planning, you might be confused with all the variations on taxes imposed on your assets after your death. There are a lot of terms to understand, and one of these is inheritance tax.

Inheritance tax is distinct from estate taxes. It is the tax levied on the value of an estate and its assets. Not all heirs will need to pay the inheritance tax, and we’ll break down the specifics later. In addition, only a few U.S. states have such an imposition. There is no federal inheritance tax. Hence, it’s important for people living in states with inheritance tax laws to understand the finer points of inheritance tax and ensure proper estate planning.

Inheritance Tax Vs. Estate Tax

It’s easy to confuse estate and inheritance taxes, but they serve two different purposes. The main difference between the two is what entity the tax is levied upon.

Estate taxes are imposed upon your assets when they are transferred to your heirs. Your assets are liable to pay the tax liability, not the heirs themselves. The minimum threshold varies by state. However, as of 2024, assets with a gross value under $1,000,000 are not taxed in any jurisdiction (state or federal). The federal minimum for estate taxes in 2024 is $13.61 million.

Inheritance tax, on the other hand, is paid by the beneficiaries of your estate. However, this is not a federal tax and only exists in 6 states. In the six states with inheritance tax, certain family members, for example, spouses of the deceased are usually exempt. The scope of the taxable amount won’t include the gross value of the estate, only the asset the heir is receiving.

States That Impose Inheritance Tax

Which states have inheritance tax laws? If you live in any one of these six states, you can expect to pay the tax liability.

Iowa: The Iowa Department of Revenue is in charge of collecting inheritance taxes from heirs. The rate for 2024 is currently between 5% and 15%, determined by the relationship of the heir to the deceased estate owner.

Kentucky: In Kentucky, the inheritance tax is between 4% and 16%, and the beneficiaries are divided into three groups: Class A, B, and C. Those who belong to Class A are exempt. These individuals include immediate family and half-siblings.

Maryland: According to the Comptroller of Maryland, the inheritance tax rate is a flat 10% of the “clear value” of the property. The clear value is the fair market value minus certain deductions. Most relatives are exempt from the inheritance tax in Maryland.

Nebraska: According to the Nebraska Department of Revenue, the inheritance tax rate is 1% to 18%, depending on the size of the inheritance and the heir’s relationship to the deceased. After $100,000, immediate family members, except spouses, are required to pay 1%. However, rates are usually at the minimum.

New Jersey: The New Jersey Division of Taxation also divides heirs into classes A to D. The last class pays the highest rates at 16% of the inherited value.

Pennsylvania: In Pennsylvania, the rate for inheritance tax is between 0% and 15%, with lower rates for direct descendants and higher rates for other types of heirs.

As you can see, each has its own rules and tax rates. We recommend working with estate planning experts to help you get an idea of what to do to potentially avoid tax penalties and enjoy deductions.

Who Has to Pay Inheritance Tax?

The responsibility of paying tax differs from state to state, as we outlined above. However, the overarching factor is the relationship of the heir to the deceased owner of the assets.

Close Relatives or Immediate Family

In general, the surviving spouse and children won’t pay inheritance tax, no matter the amount they’re receiving. In some states, grandchildren may be included in the exemption. The rationale for this privilege is to help the immediate family with the financial burden, especially if the inheritors were dependents of the deceased person. Nebraska, however, does charge a small rate for children, siblings, and parents of the deceased.

Distant Relatives and Non-Relatives

Other beneficiaries, such as distant relatives or friends, typically face higher tax rates and fewer exemptions. The imposition can significantly reduce the value of the inheritance they receive.

Charities

Only the state of Iowa requires charities to pay inheritance tax from a deceased donor. The Iowa Department of Revenue requires 4% of the share as tax liability for some charities, religious organizations, educational institutions, and other similar groups. These groups are exempt in some cases.

Exemptions in Inheritance Tax Laws

All states exempt the deceased individual’s spouse from paying inheritance tax. This privilege serves as recognition of the financial interdependence of marriages. Hence, assets can be passed down to the surviving spouse without any tax liabilities.

Relatives may also receive an intact inheritance provided that the amount does not exceed the threshold mandated by each specific state. For example, Nebraska won’t start charging the 1% tax rate to children and grandchildren until the amount is over $40,000. Any amount after this will be taxable.

How To Calculate Inheritance Tax

The formula will depend on a lot of factors, such as the beneficiary’s classification, the amount of the inheritance, and the state. For example, say that a Nebraska resident with significant assets wants to leave behind something for her brother and her nephew. She leaves $120,000 to her brother and $50,000 to her nephew.

Without any exemptions, their inheritance taxes would be calculated like this:

Her brother, an immediate relative, has to pay 1% on anything over $100,000. His tax obligation would be calculated like this: ($120,000 – $100,000) x 0.01 = $200.
The deceased’s nephew, a remote relative, must pay 11% on anything over $40,000. His inheritance tax would be calculated as follows: ($50,000 – $40,000) x 0.11 = $1,100.

If the individual lived in Pennsylvania instead of Nebraska, the inheritance tax would be calculated as follows:

The deceased’s brother, since he is a sibling, would pay 12%: $120,000 x 0.12 = $14,400.
Her nephew would owe 15%: $50,000 x 0.15 = $7,500.

Potentially Minimizing or Avoiding Inheritance Tax

There are three primary methods that may help minimize inheritance tax, especially in states where even children of the estate owners still need to pay the tax liability.

Insurance

The death benefit from a life insurance policy is not taxable. As such, you can set an insurance policy that is equal to the amount you wish to bequeath to your children or other close relatives. This method is not always foolproof, as the insurance proceeds may be included in the estate’s value if the policyholder retains ownership of the policy.

Gifting

You can begin gifting the assets to your chosen beneficiary during your lifetime. This action can eliminate inheritance tax altogether. However, you need to be mindful of gift tax. Make sure to stay within the annual gift tax exclusion limit. Any amount after the threshold must be reported to the IRS.

Trust

Putting an asset in an irrevocable trust removes it from your estate. When the beneficiary receives the asset, it won’t be classified as an inheritance. Keep in mind that trusts are a complex legal structure. You will need to work with a trust attorney to ensure that you comply with state tax laws.

Filing and Paying Inheritance Tax

The steps for filing and paying inheritance taxes vary from state to state, and the governing body will be the state’s tax authority, which is typically the Department of Revenue. The executor usually values the deceased assets, including the amount of the inheritance each heir will receive. In addition, the executor will file the tax forms and submit the documents to the state’s tax authority.

If you’re a beneficiary who received an amount that exceeds the limits, then you’re responsible for paying the tax. The executor will inform you, and you must pay within the specified time frame mandated by your state’s tax authority. In general, you’ll be required to pay once the return is filed. Unpaid tax payments will become delinquent nine months later, subject to fines and penalties if you leave it unpaid. However, some states will allow installments, especially if the amount is significant.

Common Mistakes and How To Avoid Them

There are a few pitfalls that could result in beneficiaries paying high amounts of inheritance tax and penalties.

Underestimating the Value of Assets

In some cases, the estate owner may overlook or underestimate the value of their assets. This mistake can result in incorrect tax calculations. Having professional appraisal and proper documentation can help prevent these errors. Plus, you must choose an executor who has a good grasp of these processes and requirements, such as a trustee company or your family lawyer.

Filing Past the Deadline

As we mentioned above, most states that require inheritance tax usually require filing and paying within a nine-month limit. After this deadline, the tax payments are considered delinquent, and the beneficiaries will need to pay penalties. The executors and heirs must communicate together to ensure timely payment of the tax liabilities.

Misunderstanding Deductions, Exemptions, and Beneficiary Classifications

Each state has its own rules and mandates for inheritance taxes. Beneficiaries who are unaware of the specific rates, thresholds, and beneficiary classifications could end up paying more than what they need to. It’s important to work with tax professionals within your state to take advantage of applicable exemptions.

Future Trends To Consider

For estate planners, it’s important to consider future trends and possible legislative changes that could affect inheritance tax. For example, Iowa is already planning to phase out inheritance tax. Beneficiaries will no longer need to make payments, no matter their relationship with the deceased or the amount they receive, starting January 1, 2025.

Other states have started initiatives to eliminate inheritance tax, but the laws remain unpassed. There are some efforts for higher exemption thresholds, which help reduce the burden among beneficiaries.

It’s important to stay on top of these new laws and trends to ensure proper estate planning. For heirs, knowing the current limits can help you avoid paying too much — or you may be able to pay nothing at all.

Wrapping Up: How Does Inheritance Tax Work

Inheritance tax is among the top tax considerations for both estate planners and beneficiaries. This is the tax that heirs must pay after receiving assets from a deceased individual. Only six states still apply this requirement. If you live in Iowa, Kentucky, and the others we mentioned, you must pay the inheritance tax. The total payment depends on your relationship with the deceased individual and the rate each state imposes.

Given the complex nature of inheritance taxes, we recommend working with tax professionals. They can help you pay on time and avoid any errors that could result in penalties and fees. By taking these steps and staying informed, you can better preserve your wealth as the asset owner. Beneficiaries, on the other hand, can avoid common pitfalls and may potentially receive the highest amount from their inheritance.

The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.