As George Harrison of the Beatles famously wrote in his hit song "The Taxman," citizens seem to be taxed on everything, including death itself. Harrison's advice to be sure and "declare the pennies on your eyes" was obviously satire directed at the notoriously high levies in the United Kingdom. In the United States, we are not exempt from high taxes, although there is confusion about the difference between inheritance taxes and estate taxes.
No Federal Inheritance Taxes
While the U.S. levies a transfer tax on estates, there is no federal inheritance tax. According to the IRS, the estate tax is a tax on your right to transfer property at the time of your death. The estate consists of everything you own or have an interest in when you die, including cash, property, securities, trusts, real estate, business interests, and any other assets. To determine whether an estate must pay taxes, the executor will determine the estate's total value minus liabilities.
Who Pays Estate Taxes?
Most taxpayers avoid estate taxes due to the high threshold for imposition of the tax. The Tax Cuts and Jobs Act increased the minimum from $5.47 million to $11.7 million (now $12 million for taxpayers who die in 2022), which means far fewer than one percent of taxpayer estates are affected. Keep in mind that the provisions of the TCJA are due to expire in 2026. Unless Congress extends all or some, the changes will revert to their previous levels.
If an estate value exceeds the threshold amount, the tax rate on the amount over the threshold can go as high as 40 percent. It’s also helpful to note that in the event that the heir is receiving property, they will pay any taxes on the “stepped-up” value of the asset, rather than the adjusted basis that the original (deceased owner) would have paid if selling the asset. That means that the beneficiary starts with a cost basis of the asset's fair market value when they acquire it, notwithstanding what the person who gave it to them paid for it.
What About State Inheritance Taxes?
First, twelve states and the District of Columbia have estate taxes on top of those the federal government imposes on estates, each with its own thresholds, rates, and exemptions. But six states also have inheritance taxes that the person inheriting money or property must pay in various amounts. The tax rate ranges from one percent to 18 percent, and in some of the states, the rate depends on the amount of the bequest. In others, certain relationships are exempt from the imposition of taxes.
While spouses are almost always exempt, recipients may pay different rates depending on whether they are close relatives like parents, children, and siblings of the decedent or more distantly related to the giver. Your financial advisor can guide you through the intricacies of the situation if you are in one of the states that imposes an inheritance or estate tax.
