What Is Inheritance Tax And How It Works
In this guide, we'll look at what inheritance tax is and how it works. We'll also dive into how it differs from the federal estate tax, among other relevant topics.
The taxes mentioned above are different from each other, something that most people miss when discussing them. Each of them has their practice and concepts in the application, which are essential to understand.
Additionally, not everyone knows whether inheritance is taxable and if it is – some still don't understand how it works. Every heir does not have the habit of paying inheritance taxes, just like not every estate will pay the estate taxes. It's also essential to understand how the taxes mentioned above can affect you as an inheritor or a benefactor.
Defining Inheritance Tax
Some states impose an inheritance tax on those who inherit assets from the deceased. The tax rate is different in all the states because of influence from several factors. Some of these factors include the inheritance value, the inheritor's relationship to the benefactor, and the state of residence.
Therefore, this type of tax is levied on the inherited assets from a deceased person's estates. Note that there is no federal tax, and currently, only six states in the nation charge inheritance.
These six states include:
- New Jersey
Inheriting a deceased person's assets in the states mentioned above will require you to file a state tax form. If not, the state of residence will start looking for interests and penalties for you to accommodate.
Who Pays the Inheritance Tax?
The U.S government doesn't impose taxes on the people who receive assets from the deceased's estates. Instead, it taxes large estates directly, unlike the six states mentioned above, which levy inheritance tax.
The rate of this tax depends on several factors, which include:
- The value of the assets acquired
- Inheritor's relationship to the benefactors
- Laws and policies of each of the six states mentioned above
In the same line, life insurance that is payable to a determined beneficiary isn't usually taxed. However, the case is different when life insurance is owed to the deceased person's estate. When this is the case, life insurance is usually subject to estate taxation. Understand that the value of the deceased's estate plays a role in estimating the estate tax.
However, an inheritance tax is levied on the value of the inheritance left to the decedent's beneficiary. If an inheritance tax is due, it's only applied to the sum that surpasses the exemption amount. And this tax is typically assessed on a sliding basis above the expected thresholds. The rates of inheritance tax usually range depending on several factors, as mentioned above. These rates can start from a single-digit percentage and rise to reach about 15%-18%.
The beneficiary's rate and exemption depending on the relationship between the two parties more than the inheritance value. The closer you were to the deceased, the higher the exemption, and ultimately, the lower rate you'll pay. From such realization, all the six states allow surviving spouses an exemption from inheritance tax. Additionally, the only descendants that pay inheritance tax are the ones living in Pennsylvania and Nebraska.
Note that this type of tax is thoroughly assessed by the state of residence of the inheritor.
The Threshold Minimums
Inheritance tax thresholds differ in all six states, with each of them having an absolute threshold minimum. In Maryland, estates worth less than $50,000 are on tax exemption. Similarly, in Iowa, estates valued at $25,000 or lower aren't subjected to taxation when passed down to the recipients.
There are more exemptions for beneficiaries of an inheritance, but it depends on the beneficiary's relationship to the deceased. Below are some of the threshold minimums for inheritance tax in the six states that impose this type of taxation.
Pennsylvania – Surviving spouse and available charities are exempted, while specific family members get up to $3,500 in the exemption.
Maryland – Charities and family exempt, but other beneficiaries get up to $1,000 in the exemption.
Iowa – immediate family, exempt only with charities getting up to $500, and other recipients receive none.
Nebraska – Surviving spouse and charities get exempt, while other recipients get exempt from $10,000-$40,000.
Kentucky – The immediate family and charities get exempt, while other inheritors get $500-$1000 exempt
New Jersey – In this state, the deceased and charitable organizations' immediate family gets exempt. Other family members get a $25,000 exempt, while other recipients are denied any exempt minimum.
There you have it, the threshold minimums available in all the six states that impose the inheritance tax. As you've seen, the closer recipients are to the benefactor, the higher the level of exemption.
Inheritance Tax vs. Estate Tax
Although these two taxation forms have been linked with similarities, they are quite different from each other. But one of their similarities is that they are both based on the fair market value of the benefactor's property.
The estate tax is levied directly on the estate left by the deceased person before the distribution happens. On the other hand, the inheritance tax calculation considers only the value of the beneficiary's inheritance.
Quoting from the Internal Revenue Service, the federal estate tax is imposed on estates with a valuation of $11.58+ million in 2020. But if the estate is left to the deceased's spouse, there will be no assessment of the inheritance tax.
If the estate left triggers an estate tax's attention in a state where inheritance tax is levied, both taxes are payable. In this case, the estate tax is first assessed before proceeding to evaluate the inheritance tax.
That said, hopefully, you've understood the difference between Estate tax and Inheritance tax. They might appear similar, but they are different and don't affect everyone, as you've learned. In conclusion, it's also good to know that the inheritance tax bears a certain level of unpredictability.
This is because the rates, exemptions, and laws regarding this type of tax may change depending on the states.
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