Main Differences between Inheritance Tax and Estate Tax
The death of a relative passes many things on to family members. There would be sorrow, pain, expenses, and real estate if the deceased had any such property. Even with the family grieving, certain costs related to federal-level and state-level taxes must be attended to as soon as possible.
Inheritance taxes and estate taxes are two separate kinds of taxes incurred upon the transfer of real estate property from one person to another, especially in the case of the death of a loved one. The differences between them will be explored below to help you understand them better and help you know which responsibilities you have to take up. Armed with the knowledge of the differences, you can plan ahead of time and navigate the process more smoothly.
What are Estate Taxes?
The federal government imposes estate taxes on one’s assets after death for the transfer of an estate to a beneficiary. However, anything left to the spouse of a United States of America citizen, or gifts to a charity, is tax-exempt.
The actual tax to be paid only pertains to estates that surpass a specified value. In 2021, that value is $23.4 million for married couples and half of that ($11.7 million) for individuals. Typically, you would have to pay a base tax and a progressive rate between 18% and 40% based on the amount by which the threshold is exceeded. Low rates of the taxable amount could range from one dollar to ten thousand dollars, while it could exceed a million dollars for the high end.
Let’s take a look at this example: You have an individual estate worth $12 million. The amount that exceeds the threshold of $11.7 million is $300,000 ($12 million – $11.7 million); therefore, $300,000 is the total taxable amount. The applicable base tax you would pay is $70,800 in addition to 34% of the amount by which that same $300,000 exceeds $250,000. This amount equals $50,000 ($300,000 – $250,000) and 34% of $50,000 equals $17,000. The amount of $17,000 is then added to the applicable base tax of $70,800. When added, the total tax bill becomes $87,800.
Apart from the federal-level estate tax, you might be liable for a state-level estate tax as well. This depends on which state you lived and died in. Each one has a different rate, so you must find the marginal rate and base threshold that correspond to your state. The following are states that impose estate taxes.
- New York
- Washington, D.C.
- Rhode Island
What is Inheritance Tax?
Inheritance tax is the tax imposed on the property that a beneficiary receives from the deceased. Beneficiaries are responsible for paying inheritance tax, while the deceased is responsible for paying estate tax. Just some states make use of it, and when they do, it is used instead of the estate tax. These states include:
- New Jersey
Maryland is the only state of them all that makes use of both inheritance and estate tax. Even if you do not live in those states, but you inherit property from someone that lived in Kentucky, for example, then you are likely liable to pay tax to the state of Kentucky. The amount of taxes paid by beneficiaries differs from person to person, as it depends on your relationship with the deceased and how much you receive from the inheritance.
Exemptions exist that could enable you to receive the assets passed on to you without paying inheritance tax on them if they apply to you. An example of this is the state of New Jersey that exempts children and a surviving spouse from having to pay inheritance tax on property left to them. However, the siblings of the deceased are liable. The state of Maryland also exempts direct descendants, and a surviving spouse from paying an inheritance tax on property passed to them.
Key Differences between Inheritance Taxes and Estate Taxes
i. The key difference boils down to who the financially responsible party is for the taxation of the property’s transfer. When it comes to inheritance tax, the inheritor of the property is liable to pay in order to receive the assets. Distinctively, it is the decedent and their estate that is financially responsible for estate tax payment.
ii. Inheritance tax is only imposed on a state level, while estate tax can be imposed at both the state and federal levels.
Take a look at this example:
When Grandpa Greg passed on, he owned several assets with the value of $2.5 million. Later, liabilities and other residual payments were made. These payments amounted to $500,000, which resulted in the net estate being valued at $2 million for estate tax purposes. This amount is below the federal threshold for tax exemption of $11.7 million, so this means that Grandpa Greg’s estate is not liable for federal estate tax.
Assuming that Grandpa Greg lived in Oregon, he would have to pay estate tax since the estate tax exemption threshold there is $1 million. The amount that surpasses the baseline of $1 million is taxable. The tax payable includes the base tax of $50,000 in addition to the marginal rate of 10.25% (10.25% of $1 million = $102,500). Summing them will provide us with the estate tax that has to be paid to the state of Oregon. $50,000 + $102,500 = $152,500. The total estate tax on Grandpa Greg’s $2 million estate is $152,500. Oregon does not impose an inheritance tax.
Let’s move Grandpa Greg and his $2 million estate to the state of Pennsylvania to see how inheritance tax applies there. The percentage to be paid by the beneficiary depends on their relationship to the deceased. In Pennsylvania, children not up to the age of 21 and surviving spouses are not taxed on the transfer of the property. Alternatively, the state imposes a tax of 4.5% on children and grandchildren that are 21 years or older, 12% tax on siblings, and a tax of 15% on other heirs (This does not include exempt organizations).
If Grandpa Greg were to transfer his estate to his brother, he would be exempted from estate tax since the $2 million does not surpass $11.7 million. His brother would, however, pay a 12% tax that amounts to $240,000.
What to do
If you have an estate that you plan to transfer to loved ones after your passing, it would be beneficial to plan the transfer in a way that would minimize their tax burden. To do this efficiently and abide by the law, you should find a professional that can help you create an estate plan that works best for you.