Having a loved one pass is always difficult. Sometimes it’s made more difficult by taxes affecting how the deceased passes on their estate. If you’re planning on leaving your estate to loved ones, especially any outside of your immediate family, you can take some of the burden from them by paying attention to this inheritance tax guide.
Inheritance taxes only affect residents in six states and mainly affects distant relatives or those completely unrelated to the deceased person. It’s important to be aware of the inheritance tax in your state as it can kick in at as little as $500.
What Is an Inheritance Tax?
An inheritance tax is a tax imposed by certain states on those who inherit assets from the estate of a deceased person. The amount or rate of tax owed depends on the decedent’s state of residence, the value of the inheritance, and the beneficiary's relationship to the deceased person.
There’s no federal inheritance tax and most states don’t impose one at state level. Inheritance tax is levied in only six states: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Only if the benefactor lived in one of these states is inheritance tax owed, the beneficiary’s residency isn’t considered.
Who Has to Pay an Inheritance Tax?
Very few beneficiaries are subject to inheritance tax. Surviving spouses are exempt in all six states and in New Jersey domestic partners and civil union partners are also exempt. Direct descendants are typically exempt too except in Nebraska and Pennsylvania.
Generally the closer you’re related to the decedent the higher the exemption and lower the tax rate. Organizations and people not related to the benefactor can be subject to rates up to 18% and exemptions as little as $500.
How Much Is the Inheritance Tax in 2021?
Inheritance tax rates vary greatly by state, size of inheritance, and the beneficiary’s relationship to the deceased person. While spouses in every state are exempt, immediate family in Nebraska is subject to a 1% inheritance tax. And in Pennsylvania it’s 4.5%
All states exempt charitable organizations from inheritance tax except Iowa which is 10% to 15% based on the size of the gift. Most states increase the tax rate as the inheritance increases and the further away the beneficiary is from immediate family.
| Immediate Family* | Charitable Organizations | All Others | |
|---|---|---|---|
Exempt | Exempt up to $500 then taxed 10% to 15% | 5% to 15% of inheritance | |
Exempt | Exempt | Exempt up to $500-$1,000 then taxed at 4% to 16%. | |
Exempt | Exempt | 10% of the “clear value” of the inherited property valued at $30,000 or more. | |
Spouses exempt. Immediate family (parents, grandparents, siblings, children, grandchildren) exempt up to $40,000. Tax rate is 1%. | Exempt | Remote relatives exempt up to $15,000 then taxed at 13% & all others exempt up to $10,000 then taxed at 18%. | |
Exempt | Exempt | Brother, sister, son-in-law, and daughter-in-law exempt up to $25,000 then taxed at 11% to 16%. All others taxed at 15% to 16%. | |
Spouse and minor children exempt. Adult children, grandparents, and parents exempt up to $3,500 then taxed at 4.5%. | Exempt | Siblings are taxed at 12% and all others are taxed 15% with no exemptions. |
- spouse, children, parents, grandparents, grandchildren
Inheritance tax is far less than estate tax which can be as high as 40%. If you’re subject to inheritance tax you’ll pay no more than 18%.
Inheritance Tax vs Estate Tax
Estate and inheritance taxes often get confused as the same tax but they’re completely separate. In fact, if a person inherits an estate large enough to trigger the federal estate tax, and they live in a state with an inheritance tax, they can owe both taxes.
Estate tax is based on, and comes out of, the value of the benefactor’s estate before it’s distributed. Inheritance tax is only levied on the value of the inheritance and is paid by the beneficiary at the state level.
Inheritance tax is levied at the state level and has no federal equivalent. Estate tax on the other hand is both a federal and state tax. As of 2021, a dozen states and one district have a state level estate tax: Connecticut, District of Columbia, Hawaii, Illinois, Maine, Massachusetts, Maryland, New York, Oregon, Minnesota, Rhode Island, Vermont, and Washington State.
Maryland is currently the only state that imposes both a state-level estate tax and an inheritance tax in addition to the federal estate tax.
How do you avoid inheritance tax?
There are plenty of ways to minimize or avoid inheritance tax. The first is to put assets in a trust. Assets in a trust, specifically an irrevocable trust, aren’t included in your estate and won’t count as an inheritance upon your death.
The death benefit from an insurance policy isn’t subject to inheritance taxes so purchasing a life insurance policy is another way to avoid the tax. Simply name the person you want to “inherit” the death benefit as the beneficiary.
Lastly, you can give money gradually while you’re alive. States typically don’t tax gifts and you can avoid the federal gift tax on gifts up to $15,000 per person per year. And, as of 2021, you can exclude up to $11.7 million in gifts over your lifetime.
When all else fails, if you can’t avoid it you may be able to get a discount. Pennsylvania applies a 5% discount If an inheritance tax is paid within three months of the date of death.
It’s Unlikely You’ll Have to Deal With Inheritance Tax
If you expect to receive an inheritance from someone who lives in Iowa, Kentucky, Maryland, Nebraska, New Jersey, or Pennsylvania, talk with them about strategies to avoid inheritance tax.
If you’re preparing for your estate’s distribution you can take action while you’re alive. Sit down with an attorney to set up an irrevocable trust and plan your gifts well in advance. It’s unlikely you’ll have to worry about it but it’s good to know so you can be as kind to your loved ones in your passing as you are in life.