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Inheritance Tax: Everything You Need to Know

The inheritance tax is a tax on the transfer of assets from a deceased person to their beneficiaries. The inheritance tax is often confused with the estate tax, but the two have important differences. This article will explore what is the inheritance tax, how it is different from the estate tax, how it can be avoided, and walk through an example of this tax.

What is the Inheritance Tax?

The inheritance tax is a tax on the transfer of assets from a person to their beneficiaries and is taxed to the beneficiaries of the assets. The tax is calculated on the value of the assets when they are gifted, and the tax rate is typically based on the value of the assets being inherited by the beneficiary, the relationship between the estate owner and the beneficiary, and the state they live in.

Inheritance Tax vs. Estate Tax: Main Differences

The inheritance and estate tax are both taxes on the transfer of assets from one person to another, but they are assessed differently. The estate tax is imposed on the estate of the deceased person or the person passing on the assets before they are distributed to heirs, and it is calculated on the total value of the assets when they are passed on. On the other hand, the tax on estate inheritance is imposed on the beneficiaries of those assets when passed on.

Another critical difference between the inheritance and estate tax is that there is no federal inheritance tax and only some states impose an inheritance tax. On the other hand, there is a universal federal estate tax and some states impose a state-level estate tax.

How does it work?

When a person dies, their assets are distributed according to the terms of their will, or if they did not have a will, according to the state’s laws. Depending on the value of the assets and the beneficiary’s relationship to the deceased, these gifts may be subject to paying inheritance tax.

There is no federal inheritance tax, but some states have a tax on inheritances. However, even in states with an inheritance tax, it does not apply to any assets distributed to their spouse and specific types of assets and certain other beneficiaries based on each state’s rules.

What states have to pay the inheritance tax?

The six states that impose this type of tax are:

  1. Pennsylvania
  2. Maryland
  3. Iowa
  4. Nebraska
  5. Kentucky
  6. New Jersey

Inheritance Tax Exemption

A tax exemption is a type of tax relief that allows certain people or organizations to be exempt from paying certain taxes. This can include income taxes, sales taxes, and property taxes. Fortunately, if you live in a state with an inheritance tax, you may still be eligible for a tax exemption for the inheritance tax. Here are some examples of potential inheritance tax exemptions:

  1. Spousal Exemption: Spouses who are married can transfer assets to each other tax-free, and the surviving spouse receives an inheritance tax exemption when receiving assets from their spouse.
  2. Charitable Donations: Donations made to qualified charitable organizations are exempt from these taxes
  3. Family Members: Immediate family members, such as children and parents, may also be exempted from inheritance taxes (or receive a lower tax rate) depending on the state.
  4. Tax-Free Gifts: You may receive up to a certain amount of assets without being subject to the inheritance tax based on each states rules.

How to Avoid It?

There are several ways to avoid or reduce the amount of inheritance tax owed outside exemptions. Common strategies are to:

  • Give the assets to the beneficiaries as early as possible. This allows the appreciation of the assets to avoid the inheritance tax .
  • Setting up a specific types of trusts can help allow your assets to be passed on without being subject to the inheritance tax. Three common trust structures used to do so are:
    • Spousal Lifetime Access Trusts (SLAT): With a SLAT, you can place assets into the trust, and your spouse (and, in practice, you) can access the assets during your lifetime. Your children and other descendants can also be named as beneficiaries. Often, the trust is structured so that the children only become primary beneficiaries after your spouse’s death.
    • Grantor Retained Annuity Trust (GRAT): 99 of the 100 wealthiest Americans use a trust structure to pass assets on to future generations. With a GRAT, you can place assets into the trust, any appreciation above a set percentage will pass to your beneficiary or trust estate tax-free, and you won’t use up any of your lifetime gift exemption. As a result, you can substantially reduce the size of your taxable estate while passing on assets to your heirs if you are willing to give some assets away to beneficiaries during your lifetime.
    • Dynasty Trusts: Designed to help individuals and families preserve their wealth, reduce or avoid estate taxes, and ensure that assets are managed and distributed according to their wishes over multiple generations.

Inheritance Tax Example

If Bob was a resident in a state that has an inheritance tax, let’s say Pennsylvania. And he passed away, leaving his $4m estate to his son; Bob’s son would be responsible for paying this tax on the estate. His son would owe $180,000 in inheritance taxes. However, if Bob had properly planned out his estate before his death with early gifting or trusts, his son might not have had to pay inheritance tax on property.

Conclusion

Inheritance tax can be a significant burden for beneficiaries. It is essential to understand if it applies to you, how it works, and the different strategies that can be used to reduce or avoid it. By understanding the differences between this type of tax and estate tax and the specific rules of the Pennsylvania inheritance tax, individuals can plan ahead to minimize the amount of tax inheritance their beneficiaries will have to pay.

Want to know more about these U.S. taxes? Check out our post on Pennsylvania tax rates on inheritance! Or contact our team for more information.

About Valur

At Valur, we have built a platform to give everyone access to the tax and wealth-building tools of the ultra-rich like Mark Zuckerberg and Phil Knight. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures so you can build your wealth more efficiently at less than half the cost of competitors. From picking the best strategy to taking care of all the setup and ongoing overhead, we make it easy and have helped create more than $500m in wealth for our customers.