What is an inheritance tax?
Understanding Inheritance Tax
An inheritance tax is a tax that some beneficiaries must pay when they receive money or property from someone who has died. Unlike estate taxes, which are paid from the deceased person’s assets before distribution, inheritance taxes are paid by the people who receive the inheritance.
Think of it this way: when someone leaves you money or property in their will, certain states require you to pay a percentage of what you received as tax. This is completely separate from any federal estate taxes that might apply to very large estates.
How Inheritance Tax Works
When you inherit assets, the state where the deceased person lived may require you to pay inheritance tax on what you receive. The amount you pay typically depends on two main factors:
- The value of what you inherited
- Your relationship to the person who died
Close family members usually pay lower rates or no tax at all. For example, surviving spouses often pay nothing, while children might pay a small percentage. More distant relatives and non-family members typically face higher tax rates.
States That Have Inheritance Tax
Only a handful of states still collect inheritance tax. As of today, these states include:
- Iowa
- Kentucky
- Maryland
- Nebraska
- New Jersey
- Pennsylvania
Each state has its own rules about who pays, how much they pay, and what exemptions apply. Some states are phasing out their inheritance taxes, so it’s important to check current laws.
Who Pays Inheritance Tax?
The beneficiary who receives the inheritance is responsible for paying the tax, not the estate itself. Different types of beneficiaries often face different tax rates:
Typical Beneficiary Categories:
- Class A: Surviving spouses and sometimes parents or children (often exempt or lowest rates)
- Class B: Siblings, sons-in-law, daughters-in-law (moderate rates)
- Class C: Other relatives like cousins, aunts, uncles (higher rates)
- Class D: Non-relatives and distant family members (highest rates)
Inheritance Tax vs. Estate Tax
Many people confuse inheritance tax with estate tax, but they’re different:
- Estate tax is paid by the deceased person’s estate before assets are distributed
- Inheritance tax is paid by the person receiving the inheritance after distribution
The federal government collects estate tax on very large estates, while inheritance tax is only collected by certain states. It’s possible for an inheritance to be subject to both taxes in some situations.
Common Exemptions
Most states with inheritance taxes offer various exemptions to reduce the burden on beneficiaries:
- Small inheritances below a certain threshold (often $25,000 or less)
- Life insurance payouts to named beneficiaries
- Property passing to surviving spouses
- Charitable donations from the estate
- Certain retirement accounts
Planning for Inheritance Tax
If you expect to receive an inheritance in a state with inheritance tax, consider these points:
- Find out if the state where your benefactor lives has an inheritance tax
- Understand your relationship classification for tax purposes
- Ask about the expected value of your inheritance
- Set aside money to pay the tax when it comes due
- Consider speaking with a tax professional about your specific situation
The History Behind Death Duties
Inheritance taxes have a long history. Sometimes called “death duties,” these taxes date back centuries. Many countries and states once used them as a major source of revenue. Over time, most U.S. states have eliminated their inheritance taxes due to competition from states without such taxes and changing political views about wealth transfer.
Final Thoughts
While inheritance tax affects relatively few Americans today, it’s important to understand how it works if you live in or expect to inherit from someone in a state that collects it. The key points to remember are that beneficiaries pay the tax (not estates), rates vary based on your relationship to the deceased, and only a few states still collect this tax.
If you’re planning your estate or expecting an inheritance, consider consulting with a tax professional or estate planning attorney. They can help you understand the specific rules in your state and plan accordingly to minimize the tax burden on your beneficiaries.
