An estate tax is calculated based on the net value of all the property owned by a decedent as of the date of death. The estate’s liabilities are subtracted from the overall value of the deceased’s property to arrive at the net taxable estate. Any resulting tax bill is paid by the estate. An inheritance tax is calculated based on the value of individual bequests received from a deceased person’s estate. The beneficiaries are liable for paying this tax, although a will sometimes provides that the estate should pick up this tab as well.
How an Estate Tax Works
At one point, all states had an estate tax. The federal estate tax return offered a credit toward state-level estate taxes and states based their own tax rates on this federal credit. But that changed in 2001 when federal tax law amendments eliminated the credit. Many states repealed their estate taxes as a result. Twelve states and the District of Columbia collect an estate tax in addition to the federal estate tax. States that collect an estate tax typically offer exemptions and the value of these exemptions can vary. Only the net value of an estate that exceeds the exemption amount is taxed, and the tax comes off the top of the estate before bequests can be made to beneficiaries from anything that remains. As for the federal estate tax, very few estates find themselves liable for it, because the exemption at that level is $12.06 million in 2022 and $12.92 million in 2023.
How an Inheritance Tax Works
The federal government doesn’t have an inheritance tax, and only six states collect one. The six states with an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Indiana had one, but it’s been repealed. Maryland also has an estate tax. In general, surviving spouses are completely exempt from the inheritance tax in all six states that collect it. Four states—Iowa, Kentucky, Maryland, and New Jersey—also exempt transfers to surviving children and grandchildren, but property passing to children and grandchildren is subject to the state inheritance tax in Nebraska and Pennsylvania if the inheritance exceeds the state’s exemption amount, with is $40,000 and $3,500, respectively. More distant heirs, such as siblings, nieces, nephews, and friends, must typically pay this tax, and the tax rate tends to escalate as the degree of kinship decreases.
Example of a Taxable Estate
Say Yannick died owning assets valued at $5 million. His liabilities, including any mortgages he held and other debts, totaled $2 million at the time of his death. His net estate is, therefore, $3 million for estate tax purposes—the value of his assets minus his liabilities. Yannick’s estate would not be liable for the federal estate tax at $3 million, because this valuation is well below the $12.06 million federal exemption threshold for tax year 2022. However, his state’s exemption is only $1 million. The balance over this amount—$2 million—would be subject to a state-level estate tax. Assuming that his state’s tax rate is 15%, John’s estate would owe $300,000 before any bequests could be made—15% of $2 million. The remaining $1.7 million balance would pass to his beneficiaries or heirs.
Example of a Taxable Bequest
Yannick left his best friend a home valued at $500,000, and John’s state also collects an inheritance tax of 15% from nonrelatives. His friend, who isn’t related to him, is liable for the inheritance tax on this amount. She would owe the state $75,000 for her receipt of the house, assuming that Yannick’s will didn’t indicate that his estate would pay the tax.
The Bottom Line
You might want to choose your beneficiaries carefully so as to avoid having them incur a state inheritance tax. That might mean excluding brothers, sisters, nieces, nephews, and friends, however. You can also provide that your estate will pay the inheritance tax, but that would leave less for your beneficiaries overall. This option isn’t available in a state that collects an estate tax.
