Estate Tax vs. Inheritance Tax

There are two different types of taxes levied on estates and their beneficiaries: an estate tax and an inheritance tax. An estate tax is imposed when someone's assets transfer from a deceased person's estate to his or her beneficiaries or heirs. It is paid from the proceeds of the estate itself and must be remitted before any remaining assets can be distributed.

The estate tax is a federal tax, but some states also impose additional estate taxes.

An inheritance tax is assessed on the legacies that go through the probate process and are subsequently received by a beneficiary. It is not paid out of estate assets. Each beneficiary is responsible to pay an inheritance tax. That cost is a percentage of the total value of his or her inheritance.

Unlike the estate tax, an inheritance tax is only assessed locally.

The Estate Tax

The original purpose of an estate tax in the United States was to prevent the accumulation of dynastic wealth – the trickle down of family riches that would pass untaxed from generation to generation. The idea is rooted in America's anti-aristocratic traditions and endorses the principle that vast discrepancies in affluence are harmful to the country's social cohesion. Thus, the estate tax exists not just to raise revenue but as a way to promote greater economic equality and reduce real or perceived imbalances in the nation's communal structure.

Not surprisingly, the notion of an estate tax is a matter of much political wrangling. Modern opponents label it a "death tax." They say that it punishes the hard work of successful people who want to leave their financial legacies to their heirs, discourages capital accumulation and entrepreneurship, and distorts business decisions because of its high rate. (That rate is now 40 percent but was once as high as 77 percent.)

Regardless of the politics, the federal estate tax, originally enacted in 1916 and amended as recently as 2012 by the American Taxpayer Relief Act, only applies to a tiny segment of the public – barely 0.3 percent of all estates.

Because the first $525,000 of an individual's and $10,500,000 of a couple's estate are excluded from the tax in 2013, only 3,800 estates are expected to pay a total of $14 billion to the U.S. Treasury, this year.

How the Estate Tax Is Levied

A federal estate tax return must be filed within nine months after the date of death if a decedent's "gross estate" is more than the amount exempted for that year ($5 million or $10 million + inflation). The gross estate consists of every asset or property that a decedent had an interest in at the time of death, including individually owned property, jointly owned property, property held in trust, life insurance, pensions and annuities, stocks and bonds, and certain gifts made over the decedent's lifetime.

However, the federal government's estate tax is imposed only on a decedent's "taxable estate," i.e. that which is left over when the statutorily set exemptions, plus certain other deductions, are subtracted from the decedent's gross estate.

These deductions include:

The Marital Deduction: All property of a decedent's gross estate that passes to a surviving spouse are typically tax-free, including life insurance proceeds
The Charitable Deduction: Property left to a qualified charity can also be deducted
Mortgages and debts owed
Administration expenses of probating an estate including funeral costs
Any losses incurred during estate administration because of valid claims against the estate

In addition, 15 states and the District of Columbia impose their own estate tax. Of these states, only three have exemptions tied to the federal exemption amount. The remainder have exemptions that are lower. So in most states, estates that aren't large enough to pay federal estate taxes may still be subject to a state tax.

States that impose an estate tax:

Connecticut
Delaware
Hawaii
Illinois
Maine
Maryland
Massachusetts
Minnesota
New Jersey
New York
North Carolina
Oregon
Rhode Island
Vermont
Washington

The Inheritance Tax

The inheritance tax functions much like an income tax. It is based on the total fair market value of a received legacy – cash, accounts, real estate, stocks and bonds, business interests, vehicles, jewelry, artwork, etc.

There is no federal inheritance tax and currently only eight states impose one: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. However, even if a beneficiary doesn't live in one of those states, he or she may still get a tax bill if the property received from a decedent was owned there at the time of death.

Each state uses its own methodologies for assessing its inheritance tax. Rates, thresholds and exemptions differ, so it is necessary for a beneficiary to find out what specific rules might apply. In general, inheritance taxes tend to be progressive – the more valuable the legacy, the higher the tax rate.

Another aspect of the inheritance tax is that it is often based on how closely a beneficiary or heir is related to the decedent. In all states, an inheritance from a spouse or domestic partner is exempt, and most inheriting children pay little or no inheritance tax. However, more distant inheritors usually pay the state's highest rates.

For example, Pennsylvania has the following basic rates:

Spouse – 0 percent
Lineal descendants – 4.5 percent
Siblings – 12 percent
Anyone Else – 15 percent

Indiana's inheritance tax is more complex. It divides heirs into three classes, each of which has its own exemption threshold. Class A heirs include direct lineal descendants (including stepchildren), and has a $100,000 exemption; Class B heirs include siblings and other close relatives and has a $500 exemption; Class C heirs include anyone else and has a $100 exemption. Its tax rates are progressive, ranging from one to five percent.