Estate Tax vs. Inheritance Tax: What’s the Difference?

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Two of the most important types of taxes to be aware of when estate planning are the estate tax and the inheritance tax. These two types of tax are sometimes used interchangeably to describe money paid to the government after death, but they are actually different. The key difference between estate tax and inheritance tax is who is paying the tax. The team at Evolution Tax and Legal is breaking down estate tax vs. inheritance tax: what’s the difference, and how we can help you optimize your tax benefits during estate planning.

What Is Estate Tax?

An estate tax is a tax bill that must be paid to the state or federal government at the time of death, and this money is paid out of the estate. The estate tax amount is calculated based on the net value of all property owned and assets held by an estate holder at the time of death. Any liabilities held by the deceased are subtracted from the calculated amount of property, which results in the taxable dollar amount of the estate. From there, the tax is determined using a percentage.

Federal Estate Tax

As of 2022, only estates valued at $12.06 million or more had to pay any federal estate tax. Due to the high exemption amount, very few estates qualify for this federal tax. If you think that your estate will be valued above the federal exemption amount, there are a few ways you can work to optimize tax benefits and reduce the taxable amount of your estate. Through gifting and other methods, you can help reduce estate tax while also reaping the benefits of giving to your loved ones while you are still around to see them enjoy the money or property you have bequeathed upon them.

State Estate Tax

Due to some historical changes in federal credits given to states that held an estate tax, many states no longer collect an estate tax. There are currently only 12 states and the District of Columbia that still require an estate to pay state taxes on the taxable amount. Similar to the federal estate tax, each state has a different exemption amount, and only estates whose net values exceed the exemption amount are required to pay taxes on the estate. The state estate taxes must be paid out of the estate before any beneficiaries can receive the amount of the estate which is allotted to them based on the estate plan and will.

What Is Inheritance Tax?

There is no federal inheritance tax, and there are currently only 6 states that still collect an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. If you inherit money from a benefactor who lives in one of these states, you may be liable to pay estate taxes on your inheritance, regardless of whether you live within a state that collects an estate tax. Unlike the estate tax, which is based on the value of the estate, inheritance taxes are based on the relationship of the inheritor to the deceased and the size of gifts they are receiving. In many cases, spouses will not pay any inheritance tax, and children will typically have very little or no inheritance tax at all. Charitable beneficiaries are often exempt from paying taxes. Other beneficiaries, such as siblings, cousins, nephews and nieces, will pay a varying percentage per state on the inherited amount.

Comparing Estate Taxes & Inheritance Taxes

Federal Estate TaxesState Estate TaxesInheritance Taxes
What Is Taxed?The estate of the deceased.The estate of the deceased.The individual gift received from an inheritor.
Who Is Liable To Pay the Tax?The estate.The estate.The individual who has received the gift.
Exemption AmountEstates valued under $12.06 are exempt from paying federal estate tax.The exemption amount varies on a state-by-state basis.The exemption amount varies by state, by inheritance amount and by the relationship of the inheritor to the deceased.
Calculation MethodAmounts over the exemption are taxed incrementally from 18% to 40%.Amounts that are valued over the states exemption amount are taxed based on the state’s tax table.Varies by state.

Estate Tax & Inheritance Tax Frequently Asked Questions

Does Each Spouse Get Their Own Estate Tax Exemption?

Each spouse is entitled to their own federal estate tax exemption amount, although this rule varies for state estate taxes. Spouses who are surviving can typically claim any unused portion of their deceased spouse’s exemption amount. This is referred to as the “portability election” and allows a surviving spouse to have an estate exemption amount above the federal limit of $12.06 million, provided their spouse did not reach the exemption amount at the time of their death.

Is It True That the Federal Estate Tax Exemption Is Going To Drop by Half in 2026?

The passing of the Tax Cuts and Jobs Act effectively doubled the federal estate tax exemption amount in 2018, but the act will expire in 2026, at which point the estate tax exemption amount may go back to the original amount, which was $5.45 million. If congress does not take action to reinstate a new act or extend the exemption amount, this is a possibility that many estate holders must consider when making their estate plan.

How To Avoid Paying State & Inheritance Taxes

The best way to avoid paying a large amount of state and inheritance taxes in the future is by reducing the value of your estate. This may involve giving up control and ownership of parts of your estate while you are still living – either through gifting or through the creation of trusts. This can be a complicated process, due to the governmental hoops you will be required to jump through to avoid paying taxes while still being in compliance with the legal system. To optimize your estate tax benefits, it is a great idea to speak with an Orange County estate planning attorney to ensure you are making the best plan for your situation. Avoiding inheritance tax can be a bit more complicated, but can also be achieved through efficient planning. Gifting while you are still alive can help beneficiaries who do not have a close familial relationship receive the amount intended without any inheritance tax being paid. You can also plan to move states, if you are very worried about the inheritance taxes that your beneficiaries will be required to pay in the future.

Estate planning can be a complicated process, especially when you begin to consider the costly estate and inheritance taxes your estate and beneficiaries will be responsible for paying in the future. It is a good idea to speak with a professional to ensure you have the most personalized estate plan that will do the most for your estate. The team at Evolution Tax and Legal has the expertise and knowledge to guide you through the complicated estate planning process, and help you optimize the benefits of having a well-rounded plan. Contact us today to begin your estate planning process today.