When you’re planning your estate, or if you lose a loved one, you might have questions about inheritance tax. Inheritance tax is a state tax that can apply as a percentage of a person’s inheritance. An inheritance tax is not an estate tax, but both types of taxes take a percentage of a deceased person’s estate as it passes to their heirs.
What’s the difference between an estate tax and an inheritance tax?
Estate taxes are different and separate from inheritance taxes. There’s no federal inheritance tax, but there is a federal estate tax. An estate tax is a tax that comes right off the top of an estate’s assets before they transfer to beneficiaries. In the case of an estate tax, it doesn’t matter who the beneficiary is. The tax is the same regardless of the named recipient.
How does an inheritance work?
When a person who has an estate dies, the estate’s executor or administrator distributes the assets to the designated heirs. A person might choose to leave their estate to their spouse, children, and/or other relatives or friends. They might make a gift to one or more charities. A person can even leave their estate to a total stranger.
A beneficiary who receives an inheritance needs to determine if they owe inheritance taxes on the amount that they receive. If they do, they need to pay that amount using a tax return. An inheritance tax is in addition to any estate taxes that the deceased person’s estate administrator needs to pay on the value of the estate.
Who owes an inheritance tax?
There’s no federal inheritance tax. That means it’s up to each state to decide whether or not to impose the tax. If a state decides to impose an inheritance tax, it’s up to them to decide how the tax works, who must pay, and how much they have to pay.
- Only a minority of states have any kind of inheritance tax. Even if you don’t live in a state with an inheritance tax, you need to consider the laws of the state where the deceased person lived. If there’s an inheritance tax in their state of residence, you might owe the tax even if you don’t live there yourself.
- Whether you owe an inheritance tax depends more on your relationship to the deceased than it does how much money you get. Based on your relationship to the deceased, there may or may not be an exemption up to a certain amount. For example, if you’re a relative, you may not have to pay an inheritance tax on an amount less than $50,000. On the other hand, you might need to pay from the very first dollar.
- Spouses are exempt from an inheritance tax in most states. Charities are also usually exempt. Children have generous exemptions as well, or they pay very low rates in most states. More distant relatives and non-relatives are more likely to have to pay an estate tax.
How much do I have to pay?
The amount of the estate tax varies based on the amount you inherit and your relationship to the deceased. The rate may be as low as one percent or it may be as high as 20 percent. The rates may also increase as the amount goes up similarly to how federal income taxes have varying brackets depending on income.
Consider other taxes
According to the IRS, most of the money in a large estate usually comes from capital gains. However, a large estate might have retirement accounts, bank accounts, income from work, or investment income. Some of these assets might immediately transfer to a beneficiary when the original owner passes. You should evaluate the asset to determine if you owe income taxes in addition to other types of taxes. An estate planning or tax attorney such as the Scottsdale Estate Planning Attorney locals have been trusting for years can be of great assistance when it comes to minimizing your inheritance tax.
A special thanks to our authors at Arizona Estate Planning for their expertise in Probate and Estate Law.