Inheritance tax: what is it and how much is it?
If you are looking to pass on your assets when you die, there’s a chance that those left behind may be charged with inheritance tax. Knowing the details, such as where in the US inheritance tax is applied, and the difference between inheritance tax and estate tax, may help you to plan for your financial future.
While the number of jurisdictions where inheritance tax applies is limited, and the size of an estate to be charged is large, it’s useful to know the fundamentals — even if it’s simply to establish whether you are exempt.
What is inheritance tax?
Inheritance tax is a tax that is imposed on recipients of inherited assets.
If applied, the state will charge beneficiaries a tax on a percentage of the value of a deceased person’s assets.
However, there is no federal inheritance tax, meaning that the US government doesn’t impose taxations on inheritance.
It is not particularly common to be levied with inheritance tax in the US.
It is only currently applicable in six states, and even then it is dependent on the state that the deceased person lived or owned property in.
Plus, other factors like the value of the inheritance and the relationship between the deceased and the beneficiary can offer exemptions.
The six states in which inheritance tax is applicable are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.
How does inheritance tax work?
When inheriting an asset, some of it will be exempt from taxation.
Calculating inheritance tax means only applying it to the portion that exceeds the exemption amount. Anything above this threshold tends to be assessed on a sliding scale; generally, taxation will be applied in the single digits to start, and can rise to anything between 15 per cent and 18 per cent.
Your relationship with a beneficiary will also impact how large the exemption amount is, and the rate at which it is charged.
The closer your familial relationship with the beneficiary, then usually the higher the exemption rate and lower the taxation rate will be.
How much is inheritance tax?
An inheritance tax is paid once all federal estate taxes have been paid, along with any other financial obligations.
Since there is a sliding scale of inheritance tax, there is no set amount for how much a person might expect to pay.
Plus, the tax rates can differ by state; while Maryland only charges up to 10 per cent on a sliding scale, Nebraska charges up to 18 per cent, and other states fall in between these rates.
The different types of inheritance tax
Inheritance tax can come in many forms, but ultimately will be applied to the various assets that may be passed on to a relative or friend.
These may include:
If you live in one of the six states that apply inheritance tax, and leave any of the above as part of an inheritance, your beneficiary will need to file a state tax form.
But remember, tax rates vary between each of these six states.
Inheritance tax in different states
Across the six states in which inheritance tax applies, there are varying degrees of taxation rates and exemptions.
These are outlined below:
Iowa: Inheritance tax rate ranges between 5–15 per cent on beneficiaries, but immediate family members (spouses, parents, and children) are exempt, while charities are exempt up to $500.
Kentucky: The sliding scale of inheritance tax, based on the size and including a minimum amount, ranges between four–16 per cent, but immediate family members (spouses, parents, children and siblings) are exempt. Other recipients are exempt for up to $500 or $1,000 depending on additional factors.
Maryland: The inheritance tax rate is 10 per cent. Immediate family (parents, grandparents, spouses, children, grandchildren and siblings) and charities are exempt from this, while other recipients are exempt for up to $1,000.
Nebraska: Inheritance tax rates are one per cent, 13 per cent, and 18 per cent for beneficiaries, but spouses and charities are fully exempt. Immediate family members (parents, grandparents, siblings, children and grandchildren) are exempt for up to $40,000, while other relatives are exempt for up to $15,000 and unrelated beneficiaries up to $10,000.
New Jersey: Inheritance tax rates range between 11-16 per cent, but immediate family (spouse, children, parents, grandparents and grandchildren), as well as charitable organizations, are exempt. Siblings and sons or daughters-in-law are exempt for up to $25,000.
Pennsylvania: The tax rates are applied at 4.5 per cent, 12 per cent, and 15 per cent depending on the relationship between the deceased and the beneficiary. However, spouses and minor children are exempt. Adult children, as well as grandparents and parents, are exempt for up to $3,500.
Inheritance tax exemptions
Many beneficiaries are exempt from inheritance tax.
Across all six states in which it applies, spouses are always exempt, while generally close family members will also have either full exemption or an exemption amount.
It is usually beneficiaries that are not related to the deceased that end up paying the highest tax rates.
Inheritance tax vs estate tax
Both inheritance tax and estate tax are widely known as “death taxes.”
However, they should be considered as two different forms of taxation.
While inheritance tax is what the beneficiary pays to receive the assets, estate tax is the amount that is taken from someone’s estate upon their death.
Another important distinction is that estate tax is a federal form of tax, while inheritance tax is not.
It remains true though that the majority of the US population is not impacted by federal estate tax.
Currently, it applies to assets over $12.06 million, and ranges across states from 18 per cent to 40 per cent.
However, there are some states that have their own estate taxes, and these have a much lower exemption threshold.
How to avoid inheritance tax
There are already a lot of exceptions and exemptions for inheritance tax, particularly for close family beneficiaries.
However, there are also additional ways that paying inheritance tax can be avoided — but these often fall to the person leaving their assets behind rather than the beneficiary.
Getting help from a financial advisor can be key to protecting your assets and making sure that your inheritance is left to the people you love the most.
One strategy for avoiding inheritance tax is to distribute assets before passing away, since many states don’t tax gifts.
And remember, these gifts don’t have to be cash, but can also include things like stocks and bonds, or cars.
Another strategy is to buy a life insurance policy that equals the amount you want to leave behind and make a person the beneficiary of that policy so they receive the money.
This is effective, since the death benefit from an insurance policy cannot be subject to inheritance tax.
There are plenty of ways to look after your money, and to ensure it is left behind in a way that suits you and your family best.
Kate has written for leading publications and blue chip companies over the last 20 years.