Losing a loved one is a tragedy that requires space to grieve, and the last thing a family needs at that time is to deal with unexpected costs. However, there are federal and state-level taxes that need to be handled if the decedent had an estate or property to pass on. Knowing the differences between estate tax and inheritance tax can help you plan ahead of time and navigate the process more smoothly. Most importantly, there may be responsibilities both the estate and the beneficiary have to manage. So, to understand these crucial “death taxes” and your possible role in them, let’s compare both.
Estate Taxes Explained
The federal government levies an estate tax on your assets after you die and pass them on to your beneficiaries. Those assets can include a range of things, such as real estate, although there are exceptions like gifts to a tax-exempt charity or anything left to a U.S. citizen spouse. In the end, the actual tax only applies to those with estates that exceed a certain value. For 2021, that threshold is $11.7 million for individual and doubled for married couples at $23.4 million.
You’ll generally pay a base tax and a progressive rate between 18% and 40% based on how much you surpass the threshold. At the low end, your taxable amount is $1 to $10,000 and at the high end is any value exceeding a million. So, for example, you might have an individual estate worth $12,000,000. The total taxable amount would be $300,000, meaning you would have to pay the appropriate base tax of $70,800 plus 34% of the amount by which that $300,000 exceeds $250,000. (See Column D in IRS Instructions for Form 706 under Table A – Unified Rate Schedule.) Since 34% of $50,000, which is the difference between $300,000 and $250,000, is $17,000, that is added to the $70,800 to get a tax bill of $87,800.
Depending on where in the U.S. you lived and died, you might be liable for a state estate tax as well as the federal level tax. These states levy an estate tax:
- New York
- Rhode Island
- Washington, D.C.
Each state has its own base threshold and marginal rate. So, if you live in any of the states above, it’s best to research its rules ahead of time to know what responsibilities a death may involve.
Inheritance Taxes Explained
While the decedent is responsible for estate taxes, the beneficiaries have to pay the inheritance tax. So, if you receive property in the event that someone passes, you might be liable to pay this tax. Only certain states use it, however, instead of the estate tax. They include:
- New Jersey
Among them, Maryland is the only one that uses both. Also, it doesn’t matter if you live outside those states. If you inherit from someone who lived in Kentucky but you live in Arkansas, you might still owe money to Kentucky.
The amount beneficiaries pay as a result of the tax varies. This is because the amount you pay can depend not only on how much you receive but also on your relationship with the deceased. Certain exceptions may apply to allow you to receive assets without paying an inheritance tax on them. For example, Maryland does not place an inheritance tax on property passed on to a surviving spouse or direct descendants. Alternatively, New Jersey doesn’t tax assets left to children or a surviving spouse, but the decedent’s siblings are liable.
Example of Estate Taxes vs. Inheritance Taxes
Ultimately, the main difference comes down to who is financially responsible for the property transfer’s taxation. In the case of an estate tax, it is the deceased and their estate. By contrast, an inheritance tax requires the deceased’s inheritor or heir to pay to receive the assets. Estate tax can come on both a federal and state level, but inheritance only comes in the latter.
For example, Sam died owning a total value of $2.5 million worth of assets. Any residual payments or liabilities were paid following his passing, which came to $500,000. His net estate, as a result, totaled out to $2 million for estate tax purposes.
Since this is below the federal exemption threshold of $11.7 million, Sam’s estate is not liable for that estate tax. However, Sam lives in Oregon, where the estate tax exemption is $1 million. Therefore, the portion of Sam’s estate that exceeds that baseline ($1 million) is taxable. That would involve a base tax of $50,000 plus the marginal rate at 10.25% ($102,500). That’s a total estate tax owed to Oregon of $152,500 on Sam’s $2 million estate.
Oregon does not have an inheritance tax, but we could move Sam and his $2 million estate to Pennsylvania. In Pennsylvania, the percentage paid by the heir depends on his or her relationship to the decedent. Surviving spouses are not taxed on the transfer, and neither are children under the age of 21. Instead, there is a 4.5% tax on children and grandchildren 21 or older, 12% tax on siblings and 15% tax on other heirs (aside from exempt organizations and institutions). So, consider if Sam wanted to pass on all of his estate to his brother. The $2 million estate doesn’t exceed $11.7 million, so there is no estate tax. Then, Sam’s brother just has a $240,000 tax on a $2 million inheritance.
Planning what happens to your estate after your passing involves quite a few factors. So, it’s important to comply with federal and relevant state tax laws carefully. You’ll want to plan your estate in a way that minimizes the tax burden on those you love when you pass. Seek out a financial professional who can help you create an estate plan that protects the people and causes you care about after your die.
Estate Planning Tips
- If you need professional help in navigating the estate planning process, consider working with a financial advisor. Finding one doesn’t have to be hard. You can get paired with local advisors through SmartAsset’s free financial advisor matching tool. If you’re ready, get started today.
- Estate planning can be complicated, but that’s especially true if you’re someone with significant wealth. To ensure you have everything you need, read up on the essential estate planning tools for wealthy investors.
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