What is federal inheritance tax vs. estate taxes?

You're not alone if you're confused about inheritance and estate taxes. Both are typically referred to as a death tax, but each type of tax does very different things and is paid to other entities.

Let's break them down.

What is an inheritance tax?

An inheritance tax is a levy beneficiaries pay when they inherit assets from someone who has died. The amount assessed varies based on the size of the inheritance as well as the beneficiary's relationship to the deceased person or decedent. The money paid goes to the state where the deceased lived.

Is there a federal inheritance tax?

No. But there is a federal estate tax in some cases.

Which states impose an inheritance tax?

According to the Tax Foundation, only six states impose state inheritance taxes:

• Maryland: 0% to 10%
• Pennsylvania: 0% to 15%
• Iowa: 0% to 15%
• New Jersey: 0% to 16%
• Kentucky: 0% to 16%
• Nebraska: 1% to 18%

(Each state's revenue department website breaks the ranges into tiers.)

According to the Tax Foundation, Nebraska has the highest top rate, and Maryland the lowest tax rates. In 2021, Iowa began phasing out its state inheritance tax, which should be eliminated for deaths occurring after Jan. 1, 2025, according to the Iowa Department of Revenue.

All six states exempt spouses, and some fully or partially exempt immediate relatives. Some states also exempt the decedent's descendants.

What is the federal estate tax?

An estate tax is a tax levied on the estate itself based on the value of the deceased person's estate at the time of death. Not all estates are subject to tax. The executor is responsible for paying the estate tax timely and before heirs receive assets. The money paid goes to the Internal Revenue Service (IRS) and, in some states, also goes to the state.

Which states impose an estate tax?

According to the Tax Foundation, 12 states and the District of Columbia impose an estate tax. They are:

• Massachusetts: 0.8% to 16% on estates at or above $1 million
• Rhode Island: 0.8% to 16% on estates at or above $1.6 million
• Illinois: 0.8% to 16% on estates at or above $4 million
• Maryland: 0.8% to 16% on estates at or above $5 million
• New York: 3.06% to 16% on estates at or above $5.9 million
• Maine: 8% to 12% on estates at or above $5.8 million
• Oregon: 10% to 16% on estates at or above $1 million
• Washington: 10% to 20% on estates at or above $2.2 million
• Hawaii: 10% to 20% on estates at or above $5.5 million
• Connecticut: 10.8% to 12% on estates at or above $7.1 million
• Washington, D.C.: 11.2% to 16% on estates at or above $4 million
• Minnesota: 12% to 16% on estates at or above $3 million
• Vermont: 16% on estates at or above $5 million

Each state's revenue department website has a breakdown of how to compute the maximum credit for state death taxes.

Massachusetts, for example, breaks down its range into 21 tiers from $0 to $10,040,000. To find how much an estate would owe in that state, the executor would plug in the estate's worth on the chart on Mass.gov's computation guide to estate taxes. Let's say the estate's worth is $240,000. That Massachusetts estate would be taxed 2.4% on any excess value over $140,000 and receive a maximum federal credit of $1,200.

In Maryland, though, the process is a bit more complicated because that state imposes an inheritance and an estate tax. The state charges an inheritance tax on the precise value of property that passes to beneficiaries. "The tax is levied on property that passes under a will; the intestate laws of succession; and the property that passes under a trust, deed, joint ownership, or otherwise," the Maryland tax website says. The county's Register of Wills collects the taxes based on where the decedent lived or owned property.

Maryland also imposes an estate tax on property transferred to a beneficiary. This tax "is required for every estate whose federal gross estate, plus adjusted taxable gifts, plus property for which a Maryland Qualified Terminal Interest Property (QTIP) election was previously made on a Maryland estate tax return filed for the decedent's predeceased spouse, equals or exceed the Maryland estate tax exemption amount for the year of the decedent's death, and the decedent at the death was a Maryland resident or a nonresident but owned real or tangible personal property having a taxable situs in Maryland," the state's tax website says.

For Maryland's purposes, "the gross estate includes all property, real or personal, tangible or intangible, wherever situated, in which the decedent had an interest." Such property includes the following items, among others:

• Annuities
• Joint assets with the right of survivorship
• Transfers made without adequate consideration
• The includible portion of tenancies by the entirety
• Certain life insurance proceeds
• General power of appointment property

The probate estate consists of individually owned or tenants-in-common property of the decedent. Non-probate property is "property that passes by the terms of the instrument under which it is held or by operation of law. The total gross estate for estate tax purposes includes probate and non-probate property," according to MarylandTaxes.gov.

In a state like Florida, where there is no estate tax, inheritance tax, or income tax, a beneficiary owes the state no tax on inherited property. Florida Constitution, Article VII, Section 5 prohibits inheritance and estate taxes. The Florida state legislature cannot enact with tax without a constitutional amendment, which requires 60% voter approval.

What is the current IRS estate tax rate?

In 2023, the federal estate tax ranges from 18% to 40% and generally only applies to assets over $12.92 million. So any assets inherited in an amount less than $12.92 million is not taxed. Estates of decedents survived by a spouse may elect to pass any of the decedent's unused exemption to the surviving spouse on a timely filed estate tax return for the decedent.

What about gifts made before death?

Sometimes, individuals make gifts before death. The IRS taxes certain gifts. The federal estate and gift tax combines the taxes on gifts made before death and inheritance.

The IRS limits the amount a person can transfer without incurring the tax. It is of no matter to the agency whether the amount transferred is a gift or inheritance upon death. That said, certain amounts are exempt from taxation. Congress, however, constantly tweaks exemption amounts, so they often change from year to year.

How does the federal estate and gift tax work?

To figure the amount of tax, add all amounts of gifts and inheritance, then deduct certain exemptions (detailed on the IRS website) from the total. If the result exceeds a particular dollar amount, the IRS applies a tax on the overage.

What are the exemptions to the federal estate and gift tax?

There are three federal estate tax exemptions:

• Annual exemption. In 2023, the annual exemption is $17,000 per person. This means an individual can gift up to that amount each year to as many people as they wish. A married couple may gift up to $34,000 per year per person. So an individual could gift everything they own this year without incurring any tax liability as long any one person's gift doesn't exceed $17,000 ($34,000 from a married couple). If an individual or married couple wants to stretch out the gifting, the annual exemption applies across future years.
• Lifetime exemption. If an individual gives more than the allowed amount, add the excess to the estate's value at the time of death to determine the amount subject to the combined Federal Estate and Gift Tax, then apply the lifetime exemption (also known as a unified credit). As of 2023, the exemption amount indexes for inflation each year.
• Spousal exemption. When assets transfer from one spouse to another, an unlimited spousal exemption applies. The surviving spouse may also use the deceased spouse's unused exemption but must indicate that choice on the deceased spouse's estate tax return, even if no tax is due from the estate.

What is the federal estate and gift tax rate?

As of 2023, the Federal Estate and Gift Tax rate is 40%. This means if the total estate value plus any gifts made in excess of the annual gift tax exemption exceeds $12.92 million, the amount over the $12.92 million is subject to the 40% tax. Like the exemptions, however, the federal tax rate is subject to change depending upon what Congress does from year to year.

Is there a way to minimize estate and inheritance taxes?

Since estate taxes vary depending on where an individual lives, one option is to move the individual's tax home to a state with no inheritance tax, no estate tax, and no income tax.

Another option is to give away funds while still living. Funds can be transferred to trusts or heirs during the individual's lifetime. Estate taxes can be significant. The savings from concerted estate planning can be massive.

Do capital gains taxes apply?

If a beneficiary sells an asset that appreciates after they inherited the asset, then a capital gains tax might apply.

The profit made, among other assets, determines the capital gains tax rate. For example, say a mother dies and leaves her son a stock portfolio worth $250,000. After three years, the son sells the portfolio for $450,000. The amount he might owe tax on is the $200,000 gain.

Sometimes, an inheritance can create taxable income (which is why having a tax home in a state with no income tax is helpful). For example, the distributions on an IRA or 401(k) given as a gift or inheritance might be taxable.

Some states have their own rules, so it's wise to seek qualified advice.

Is there any way to avoid taxes on an inheritance or estate?

There are many ways to avoid paying taxes, altogether, but the complicated processes are best laid out by a certified (fiduciary) financial planner, an experienced estate planner, and an estate and tax attorney.