Inheritance tax is a topic that often confuses people, especially when compared to the more commonly known estate tax. While both involve taxes on assets passed down after someone’s death, they are fundamentally different in who pays them and how they’re calculated. For those planning for the future or dealing with the aftermath of a loved one’s passing, understanding these taxes is essential.

What Is Inheritance Tax?

Inheritance tax is a tax paid by the beneficiaries who receive property, money, or other assets from a deceased person. This tax is not imposed by the federal government but rather by certain states. Unlike the estate tax, which is paid by the estate itself before assets are distributed, the inheritance tax falls on the individual who receives the inheritance.

Only six U.S. states currently impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. However, this number will decrease to five in 2025 as Iowa plans to eliminate its inheritance tax. The rates vary depending on the state and the relationship between the beneficiary and the deceased. Spouses are typically exempt, while other family members may pay a lower rate than non-relatives.

How Does It Differ From Estate Tax?

The key difference between inheritance tax and estate tax lies in who is responsible for paying it. The estate tax is levied on the total value of the deceased person’s assets, and it is paid by the estate before the assets are distributed to heirs. This tax is imposed by the federal government and some states, such as Washington, Oregon, and New York.

On the other hand, the inheritance tax is only paid by the heir, not the estate. It is only applicable in the states that have this type of tax. Additionally, the inheritance tax is not dependent on where the heir lives, only on where the deceased person resided at the time of their death.

Who Levies These Taxes?

The federal government imposes an estate tax, but there is no federal inheritance tax. However, states can choose to levy their own inheritance tax. As of now, only six states have an inheritance tax, and it is expected to drop to five in the near future.

State estate taxes also vary significantly. Some states, like Hawaii and New York, have high exemption thresholds, while others, like Oregon, have much lower exemptions. For example, in 2023, the federal estate tax exemption was $12.92 million per person, while Oregon’s exemption was only $1 million.

What Happens If You Don’t Pay These Taxes?

Failing to pay either the estate or inheritance tax can lead to serious consequences. For the estate tax, the IRS can impose penalties and interest on unpaid taxes. In the case of an inheritance tax, the beneficiary could face legal action if they do not pay the required amount within the specified timeframe.

It’s important to note that even if you don’t live in a state that imposes an inheritance tax, if the deceased person lived in such a state, you might still be subject to the tax. For example, someone living in Arizona but owning property in Minnesota could still be liable for Minnesota’s estate tax if the property’s value exceeds the exemption threshold.

How Can You Avoid These Taxes?

There are several strategies to help minimize or avoid estate and inheritance taxes:

• Gifts During Lifetime: You can give away assets during your lifetime, up to a certain limit. In 2024, you can gift up to $18,000 per person annually without incurring gift tax.

• Irrevocable Trusts: Setting up an irrevocable trust allows you to transfer assets out of your estate, reducing the taxable amount. Once assets are in the trust, they are no longer part of your estate, so they are not subject to estate or inheritance tax.

• Life Insurance: Purchasing a term life insurance policy can provide liquidity to heirs to cover any potential tax liabilities. This is particularly useful if the estate lacks enough cash to pay the tax bill.

What If You Can’t Avoid the Taxes?

If you find yourself facing an inheritance tax bill, it’s crucial to act quickly. Most states require payment within a few months, and failure to meet deadlines can result in penalties. If you’re unable to pay immediately, consider consulting a financial advisor or tax professional to explore options such as payment plans or temporary relief.

Final Thoughts

Understanding inheritance tax is essential for anyone who wants to plan for the future or manage the financial aspects of a loved one’s passing. While most people won’t be affected due to high exemption thresholds, it’s still wise to be informed. By using proper estate planning tools and seeking professional advice, you can ensure that your heirs are not burdened by unexpected tax liabilities.