Whether you're leaving property to someone, or expecting to inherit some yourself, you might be wondering whether there will be inheritance taxes to be paid—and, if so, by whom.
In general, there are three types of taxes that may apply to someone's property at death: inheritance tax, estate tax, and income tax. Below is an overview of all three, including the differences between them and how to avoid taxes on inheritance, if possible.
Inheritance tax is just what it sounds like: a tax on inheritance levied against what is received by a person as an inheritance from an estate. It is usually collected before the inheritance is even distributed, which means it is the responsibility of the person receiving the inheritance.
Specific to inheritance tax, federal law does not require an inheritance tax, and only six states plus the District of Columbia currently collect them: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The person receiving an inheritance is only subject to inheritance taxes in these states if the decedent had property located in one of them—the tax does not apply simply because the recipient is a resident of a state that collects inheritance taxes.
Even if the inheritance may be subject to inheritance tax, you may still be off the hook depending on your relationship with the decedent. For closest relatives, usually defined as "lineal"—spouses, children, grandchildren—there is generally no inheritance tax due. For more distant relatives, including siblings, nieces, and nephews, there is a set amount after which inheritance taxes are applied.
How much is inheritance tax? It depends on state law. New Jersey, for example, currently sets the inheritance tax threshold at $25,000 for inheritances by relatives beyond those closest as described above; this amount is, therefore, exempt from inheritance tax. From there, the inheritance tax rate in New Jersey jumps to 11% for the next $1,075,000 and increases in stages as the inheritance amount goes up.
Generally in states with inheritance taxes, if the person inheriting the property is not related to the decedent, there is no exemption amount and inheritance tax rates apply automatically. Looking again at New Jersey, the first $700,000 is subject to a 15% tax rate and after that, 16%.
Estate taxes can be applied by either the federal or state government, but a big difference between estate tax and inheritance tax is that estate tax is based upon the value of the decedent's estate and not on who receives the property.
This focus on the value of the entire estate, in fact, is what exempts the vast majority of estates from being subject to federal estate tax. For deaths in 2016, the personal federal estate tax exemption is $5.45 million, which means only about 1% of estates are affected by this 40% tax.
Of the fifteen states and District of Columbia that currently collect estate taxes, each has its own exemption amount. Maine, for example, matches the federal amount at $5.45 million for 2016, but New Jersey's exemption amount is just $675,000, the lowest in the country.
Several states have recently abolished or are in the process of getting rid of this so-called “death tax."
Although inheritances are not considered income and therefore are not subject to personal income tax, some inheritances themselves are subject to taxes. Retirement accounts are probably the most common example, as any distributions taken from a 401(k) are considered income and therefore taxable. You may also incur capital gains taxes on certain assets.
How to Avoid Inheritance Tax
One way to get around state inheritance taxes for your loved ones is to move to a state that doesn't have them, although you have to be careful to truly sever your ties with the old state or the tax officials of that state still may insist it has an interest in inheritances from your estate.
Notably, life insurance proceeds are exempt from state inheritance taxes, as are certain other gift transfers and situations, which vary by state law. Pennsylvania, for example, exempts farmland from inheritance tax so long as the land is farmed for seven years and is inherited by family members.
A living trust could be another way to avoid inheritance taxes for your heirs, but a revocable trust—one that can be changed or amended at any time—generally does not eliminate inheritance taxes, so it is important to fully understand specific state law on this matter.
Dealing with inheritance taxes can be complicated, so whether you are planning for your estate, or you're ready to file an inheritance tax return, you should consult an experienced professional familiar with applicable state law to best prepare for these taxes. When you sign up for the personal legal plan, through LegalZoom you'll have the opportunity to speak with a tax professional who can explain your options. You'll also receive unlimited 30-minute phone consultations with an attorney on new legal matters - all for one low monthly fee.