Inheritance tax: how it works, how much does it cost

What is inheritance tax?

An inheritance tax is a type of transfer tax that is imposed on an heir or beneficiary when they inherit property from the estate of a deceased person. Inheritance tax is not a federal tax and does not exist in most states. Only six states currently impose an inheritance tax on their residents.

How inheritance tax works

An inheritance tax is the tax that beneficiaries pay on the property they receive from their deceased relatives. Unlike inheritance tax, inheritance tax only applies when each beneficiary has received their inherited property. These taxes typically range from 0 to 18 percent, and the amount you pay depends on the size of the inheritance and your relationship with the deceased.

It should be noted that just because your state has inheritance tax doesn’t mean you will necessarily pay it. To consider Pennsylvania Estate Tax. Surviving spouses and children aged 21 or under will not pay inheritance tax on property they inherit from loved ones. Direct descendants and in-line heirs will pay only 4.5%, while siblings will pay 12%. The only persons subject to the maximum inheritance tax of 15% are the other heirs who are not spouses, direct descendants or brothers and sisters.

Using this information, let’s take a look at an example of what inheritance tax might look like in practice. Suppose John Doe dies and his will says his estate is to be divided equally among his wife, 25-year-old son, sister, and cousin, each receiving $ 25,000.

First, the wife will not pay any inheritance tax on her share because she is the surviving wife. As a descendant over 21, John Doe’s son will pay an inheritance tax of 4.5%, for a total of $ 1,125. Her sister will pay 12 percent inheritance tax, for a total of $ 3,000. Finally, as an heir who does not belong to any of the other categories, John Doe’s cousin will pay the maximum inheritance tax of 15%, for a total of $ 3,750.

States that impose an inheritance tax

Inheritance tax is not very common. In fact, only six states currently impose this type of tax. These six states are:

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

Among states that have an inheritance tax, Nebraska is currently the highest at 18%. Maryland currently has the lowest estate tax, at just 10 percent. It’s important to note, however, that Maryland also has an inheritance tax (also known as death tax) on estates of over $ 5 million.

As we mentioned earlier in our example from Pennsylvania, not all beneficiaries have to pay the same rate of inheritance tax. In general, the closer a person is to the deceased, the lower their inheritance tax rate. Additionally, some states allow an inheritance tax exemption, which means that a certain amount of someone’s inheritance will be exempt from tax before inheritance tax takes effect.

Inheritance tax vs. inheritance tax: Differences

It’s easy to confuse inheritance tax with the well-known inheritance tax, but the two are actually quite different. As we have seen, inheritance tax is imposed on the individual who inherits property from someone else. An inheritance tax, on the other hand, is imposed directly on the deceased’s estate before the assets are distributed to all beneficiaries.

The most common inheritance tax is that imposed by the federal government. In 2021, the first $ 11.7 million of a person’s estate is exempt from estate tax. Any amount above the exemption is taxed at a rate between 18 and 40 percent, depending on the amount of the estate.

In addition to federal estate tax, 12 states and the District of Columbia also levy state estate tax. Like the federal government, each state allows an exemption from inheritance tax. Massachusetts and Oregon have the smallest exemption at just $ 1 million. New York has the largest exemption and allows estates to pass $ 5.9 million before paying property taxes. Inheritance tax rates vary from state to state, but typically range from less than 1% to 20%, depending on the state and the size of the estate.

How to avoid or reduce inheritance tax

If you have inherited money from a recently deceased person, it will be difficult to avoid or reduce your inheritance tax, if your state requires it. However, there are several things people can do during their lifetime to reduce the amount of inheritance tax that their beneficiaries will owe.

Although life insurance products are not subject to inheritance tax, they may nonetheless be subject to the size and distribution of the deceased’s estate and the state in which they live.

Another way to reduce the amount of inheritance tax that your heirs will have to pay is to pass on your estate during your lifetime. Although large donations are taxable in certain situations, the federal government allows people to transmit up to $ 15,000 per recipient per year without requiring an income tax return. Gifts can be cash, stocks, bonds, physical assets, and more. People with a larger estate can choose to use their entire gift tax exemption each year to ensure that their estate is smaller when they die.

Finally, you can place assets in an irrevocable trust, which will help eliminate estate and estate tax requirements on the assets you bequeath. Once you transfer assets into an irrevocable trust, it is no longer considered your asset. While this means that you cannot withdraw an asset from the trust once you put it there, it also means that a tax will not be triggered on your death.

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