When a person dies, their assets could be subject to estate taxes and inheritance taxes, depending on where they lived and how much they were worth. While the threat of estate taxes and inheritance taxes does exist, in reality, the vast majority of estates are too small to be charged a federal estate tax, which, as of 2021, applies only if the assets of the deceased person are worth $11.70 million or more. That exemption increases to $12.06 million in 2022.
What’s more, most states have neither an estate tax, which is levied on the actual estate, nor an inheritance tax, which is assessed against those who receive an inheritance from an estate.
Indeed, the number of jurisdictions with such levies is dropping, as political opposition has risen to what some criticize as death taxes. That said, a dozen states plus the District of Columbia continue to tax estates, and a half dozen levy inheritance taxes. Maryland collects both.
As with federal estate tax, these state taxes are collected only above certain thresholds. And even at or above those levels, your relationship to the decedent–the person who died–may spare you from some or all inheritance tax. Notably, surviving spouses and descendants of the deceased rarely, if ever, pay this levy.
It’s relatively uncommon, then, for estates and inheritances to actually be taxed. Still, it’s helpful to know more about the various taxes associated with these assets, and who needs to pay them, and when. Want to find out if you’re likely to be stuck with an estate tax or inheritance tax and what you can do to reduce any such taxes? Read on.
A dozen states impose their own estate taxes, and six have inheritance taxes, both of which kick in at lower threshold amounts than the federal estate tax.
Federal and most state taxes are assessed only on the value of the estate or inheritance that exceeds the threshold amount.
Surviving spouses are generally exempt from these taxes, regardless of the value of the estate or inheritance.
To minimize estate taxes, taxpayers whose estates are above the threshold can set up trusts to facilitate the transfer of wealth.
For tax purposes, these levies, both federal and state, are assessed on the estate’s fair market value (FMV), rather than what the deceased originally paid for their assets. While that means any appreciation in the estate’s assets over time will be taxed, it also protects against being taxed on peak values that have since dropped. For example, if a house was bought at $5 million, but its current market value is $4 million, the latter amount will be used.
Anything in the estate that is bequeathed to a surviving spouse is not counted in the total amount and isn’t subject to estate tax. The right of spouses to leave any amount to one another is known as the unlimited marital deduction. But when the surviving spouse who inherited an estate dies, the beneficiaries may then owe estate taxes if the estate exceeds the exclusion limit. Other deductions, including charitable donations or any debts or fees that come with the estate, are also not included in the final calculation.
An heir due to receive money or assets can choose to decline the inheritance through the use of an inheritance or estate waiver. The waiver is a legal document that the heir signs, declining the rights to the inheritance. In such an instance, the executor of the will would then name a new beneficiary of the inheritance. An heir might choose to waive their inheritance to avoid paying taxes or to avoid having to maintain a house or other structure. A person in a bankruptcy proceeding might also choose to sign a waiver so that the property can’t be seized by creditors. State law determines how the waivers work.
The top federal statutory estate tax rate in 2021 and 2022.
Federal Estate Taxes
As noted above, the Internal Revenue Service (IRS) requires estates with combined gross assets and prior taxable gifts exceeding $11.70 million for the 2021 tax year to file a federal estate tax return and pay the relevant estate tax. The threshold increases to $12.06 million for 2022.
The portion of the estate that’s above this $11.70 million limit will ostensibly be taxed at the top federal statutory estate tax rate of 40%. In practice, however, various discounts, deductions, and loopholes allow skilled tax accountants to pare the effective rate of taxation to well below that level. Among those techniques is to take advantage of flexibility over the valuation date of the estate in order to minimize the estate’s value or cost basis.
State estate taxes are levied by the state in which the decedent was living at the time of death while inheritance taxes are levied by the state in which the inheritor lives.
State Estate Taxes
If you live in a state that has an estate tax, you’re more likely to feel its pinch than you are to pay federal estate tax. The exemptions for state and district estate taxes are all less than half those of the federal assessment. Some go as low, relatively speaking, as $1,000,000. An estate tax is assessed by the state in which the decedent was living at the time of death.
Here are the jurisdictions that have estate taxes. Click on the state’s name for further information from the state government on its estate tax.
Tax is usually assessed on a sliding basis above these thresholds, much like the income tax brackets. The tax rate is typically 10% or so for amounts just over the threshold, and it rises in steps, usually to 16%. The top estate tax rate is lowest in Connecticut, at 12%, and highest in Washington State, where it tops out at 20%.
The maximum rate for inheritance tax charged by any state.
State Inheritance Taxes
There is no federal inheritance tax, but select states, such as Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania, still tax some assets inherited from the estates of deceased persons. Whether your inheritance will be taxed (and at what rate) depends on its value, your relationship to the person who passed away, and the prevailing rules and rates where you live.
Life insurance payable to a named beneficiary is not typically subject to an inheritance tax, although life insurance payable to the deceased person or their estate is usually subject to an estate tax.
As with estate tax, an inheritance tax, if due, is applied only to the sum that exceeds the exemption. Tax is usually assessed on a sliding basis above those thresholds. Rates typically begin in the single digits and rise to between 15% and 18%. Both the exemption you receive and the rate you’re charged may vary by your relationship to the deceased–more so than with the value of assets you are inheriting.
As a rule, the closer your relationship with the decedent, the lower the rate you’ll pay. Surviving spouses are exempt from inheritance tax in all six states. Domestic partners, too, are exempt in New Jersey. Descendants pay no inheritance tax except in Nebraska and Pennsylvania. Inheritance tax is assessed by the state in which the inheritor is living.
Some states offer tax reductions for widows or widowers, such as a reduction in property taxes for a certain period of time. For example, in Florida, a surviving spouse is entitled to receive a reduction in the taxable value of a property they own by $500 each year, in perpetuity, or until they remarry.
Here are the jurisdictions that have inheritance taxes. Click on the state’s name for further information on its inheritance tax from the state government:
Maximize Your Gifts
Maximizing your gifting potential is another way to reduce estate taxes. As of 2021, an individual can give another $15,000 or less per year and a married couple can give $30,000 per year without having to file a federal gift tax return. The limits increase to $16,000 for individuals and $32,000 for married couples for 2022.
How to Minimize Estate Taxes
Keep the planning simple and the total amount of the estate below the threshold to minimize estate taxes. For most families, that’s easy. For those with estates and inheritances above the threshold, setting up trusts that facilitate the transfer of wealth can help ease the tax burden.
One way to reduce estate tax exposure is to use an intentionally defective grantor trust (IDGT), which is a type of irrevocable trust that allows a trustor to isolate certain trust assets so as to separate income tax from estate tax treatment on those assets. The grantor pays income taxes on any revenue generated by the assets but the assets can grow tax-free. As such, the grantor’s beneficiaries can avoid gift taxation.
You can reduce your estate taxes if you own a life insurance policy as well. On their own, life insurance proceeds are income-tax-free at the federal level when they are paid to your beneficiary. But when the proceeds are included as part of your taxable estate for estate tax purposes, they might push your estate over the cutoff. One way to make sure that doesn’t happen is to transfer ownership of your policy to another person or entity, including the beneficiary. Another possibility is to set up an irrevocable life insurance trust (ILIT).
What Assets Are Subject to Estate Taxes?
All the assets of a deceased person that are worth $11.70 million or more, as of 2021, are subject to federal estate taxes. That amount increases to $12.06 million for the 2022 tax year.
Twelve states and the District of Columbia also charge estate taxes, but the rules are different depending on the state.
What Is the Estate Tax Rate?
On the federal level, the portion of the estate that surpasses that $11.70 million and $12.06 million cutoffs will be taxed at a rate of 40%, as of 2021 and 2022, respectively.
Depending on where you live, the tax rate varies on the state level but 18% is the maximum rate for an inheritance that can be charged by any state.
What Is the Difference Between an Estate Tax and an Inheritance Tax?
An estate tax is levied on the estate itself and an inheritance tax is levied against those who receive an inheritance from an estate.
Do I Have to Pay Taxes on an Estate?
If you receive an inheritance from an estate and the assets are worth more than $11.70 million in 2021, you will have to pay inheritance taxes. The estate tax is levied on the estate itself. Keep in mind that the cutoff is $12.06 million in 2022.
How Can I Avoid Estate Taxes?
Keeping your estate under the threshold is one way to avoid paying taxes. Other methods include setting up trusts, such as an intentionally defective grantor trust, which separates income tax from estate tax treatment, transferring your life insurance policy, so it won’t be counted as part of your estate, and making strategic use of gifting.
The Bottom Line
Inheritance taxes are complex and change frequently. Most of us engage with them during a stressful and busy period of our lives. It’s wise to prepare for the inevitable by doing some homework in advance.
As long as the estate in question does not have assets exceeding $11.70 million for 2021 (or $12.06 million in 2022), you are most likely not on the hook for federal estate or inheritance taxes. But keep an eye on individual states for what their rules are since a dozen of them and the District of Columbia charge estate and inheritance taxes as well.
Monitor any changes to the laws that affect you, perhaps by setting online news alerts for the state relevant to you and the terms estate taxes and inheritance taxes. As you grow older, you can help prepare your loved ones for taxes by explaining the laws to them. You might even want to set aside a fund to help offset that tax burden when it comes. Consider, too, meeting with a lawyer, CPA, or CFP to begin planning your estate and minimizing the tax your beneficiaries will have to pay when they inherit it.