Estate and inheritance taxes are both types of taxes levied on the transfer of property at death, but they operate differently: An estate tax is levied on the estate of the deceased while an inheritance tax is levied on the heirs of the deceased.
There is a federal estate tax, which generally affects only the wealthiest Americans. The federal government does not levy an inheritance tax. However, in 2023, 12 states and the District of Columbia levied an estate tax, six states levied an inheritance tax, and one state (Maryland) levied both. That said, estate and inheritance taxes do not come into play when assets are left to a spouse who is a U.S. citizen.
State estate taxes usually are higher than inheritance taxes, and they can impact families in unexpected ways. However, they generally come into play if the taxpayer considers one of these states their permanent home or if they have property there. This means that many taxpayers can unexpectedly find themselves owing thousands of dollars, especially when they inherit real estate that has appreciated over the years since it was originally purchased. Consider this statistic: According to the U.S. Bureau of Labor Statistics, prices for housing are 936.78% higher in 2023 versus 1967 (a $936,779.24 difference in value).
You need to be proactive
So, what can be done to prevent this from happening?
- Know the tax estate and inheritance tax thresholds in your state. These rates can change for various reasons. For example, the inheritance tax rate may vary according to the heir’s relationship to the decedent or the rate may be adjusted for inflation, effectively lowering the amount of the tax.
- In most states, estate taxes are progressive: The tax rate increases with the total value of the decedent’s assets, but two states have flat estate taxes with a single tax rate. The highest top rates in the nation range from 16% to 20%. In addition, all states prevent smaller estates from being subject to these taxes by allowing certain exemptions from their estate tax. The lowest exemption is $1 million, and the highest exemption is $12.92 million.
- Taxpayers who have estates near those limits can consider giving away assets to reduce the value of their estates. Alternatively, they could include a clause in their will stipulating that any amount over the exemption amount should be given to charity.
- Be aware that:
- You may be liable for estate taxes even if you live in another state. The determination is made based on where the property is located. In some circumstances, it may make sense to relocate to a state that does not impose estate or inheritance taxes.
- In many states, married couples must create an irrevocable trust (e.g., a credit shelter trust) to take full advantage of the exemption amounts for both spouses. Similarly, living trusts, irrevocable trusts, grantor retained annuity trusts, and certain other trusts can be set up for children and other beneficiaries. Irrevocable trusts allow property to pass without an official property transfer, thus avoiding taxation. These trusts need to be part of your estate plan.
- Cash received as an inheritance is not taxable. However, if the cash later generates income, that income may be taxable.
Taxpayers with property, especially real property, located in states with high estate and inheritance tax rates should consult a tax professional to ensure their estate plans are as robust as possible.
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