What's the Difference Between the Estate Tax and Inheritance Tax?

Death and taxes might be certainties in life, but fortunately, death taxes are not. A “death tax” is an informal term that can refer to any of the taxes imposed by the federal or state government when a person dies. These taxes are not, by any means, imposed in every situation. Whether an estate or its inheritors will owe taxes depends on the size of the estate in question—that is, the total value of the deceased person’s assets at death—and the laws of the state where the deceased lived.

To find out whether an estate or its inheritors might have to pay taxes on a deceased person’s assets, consider whether any of the following applies to your situation: federal estate tax, state estate tax, and state inheritance tax.

You might have heard that leaving property behind using a simple living trust rather than a will can save inheritors time and money. But using a living trust avoids probate—the court process for transferring property to inheritors—not taxes, so if you’re dealing with a living trust, you’ll still have to consider whether the estate or inheritors will owe taxes. There are other kinds of trusts whose purpose is to save on taxes, but they are much rarer and more complicated.

Estate Tax

Estate taxes are taxes imposed on property (such as money, real estate, and physical belongings) before that property is transferred from a deceased person to the inheritors. In practice, this means that the person managing the estate (called an “executor,” “trustee,” “representative,” or “administrator”) is responsible for filing an estate tax return and paying the tax from the estate’s assets before transferring property to the inheritors.

Federal Estate Tax: Imposed on Less Than 0.1% of Estates

It’s very unlikely that your estate will owe federal estate tax; the tax doesn’t apply to estates worth less than $11.7 million dollars (for deaths occurring in 2021; for 2022, this figure is $12.06 million). The threshold amount rises each year with inflation, and is also subject to drastic change, depending on the political climate. The tax rate is quite high—a flat 40%.

Property left to a surviving spouse is always exempt from federal estate tax. The surviving spouse can then combine both individual exemptions—for a total of $23.4 million—as the threshold amount before federal estate tax applies to the surviving spouse’s estate.

State Estate Tax: Imposed by a Dozen States

Because the state threshold amounts are lower than the federal amounts, your estate might owe a state estate tax when it does not owe a federal one. But even if it owes estate taxes to the state, because the rates for these taxes are lower than the federal rates, the amount might not be too painful. For example, in Massachusetts the estate tax rate ranges from 0% to 16%, depending on the size of the estate.

To determine whether an estate will owe state estate taxes, you will need to know:

• Was the deceased a resident of a state that imposes an estate tax, and
• If so, does the total worth of the estate exceed the threshold amount for the state’s estate tax?

Inheritance Tax: Imposed by Six States

Unlike estate taxes, inheritance taxes are imposed on the inheritors of the estate property rather than on the entire estate. The total amount of estate assets is irrelevant to inheritance tax; there is no minimum threshold before the tax applies. What is relevant is the relationship between the deceased person and the inheritor—the closer the relationship, the less the tax.

Spouses of the deceased are exempt from inheritance tax in all states, and children of the deceased are either exempt or pay low tax rates. Typically, the tax rate then climbs higher the more distantly related the inheritor is to the deceased. For example, in Pennsylvania, children and grandchildren of the deceased pay 4.5% tax on inherited property, siblings pay 12%, and other inheritors pay 15%.

Only six states currently impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

If you live in one of these states, you can find the rules and rates specific to your state at the website of your state’s taxing authority.

Will My Estate Owe Estate Tax or Inheritance Tax? Some Examples

To illustrate how death taxes apply in different situations and states, here are a few simple examples.

Example 1: Owes state estate tax. Sadie lived in Massachusetts and died in 2021, leaving behind an estate worth $1.2 million. Massachusetts’s threshold for estate tax in 2021 was $1 million, so Sadie’s estate will owe state estate tax. However, it will not owe federal estate tax because the federal threshold was $11.7 million, and her inheritors will not owe inheritance tax because there is none in Massachusetts.

Example 2: Owes state inheritance tax. Dominic lived in Pennsylvania and died in 2022, leaving behind an estate worth $100,000 to his daughter. His estate will not owe federal or state estate taxes, but his daughter will owe inheritance tax.

Example 3: Owes federal and state estate taxes. Chike lived in New York and died in 2021, leaving behind an estate worth $13 million. Because the estate exceeded the $11.7 million threshold for federal estate taxes as well as the $5.93 million threshold for New York estate taxes, Chike’s estate will owe both federal and state estate taxes.

Example 4: Owes no taxes. Jorge lived in California and died in 2021, leaving behind an estate worth $10 million. His estate was not quite large enough to owe federal estate tax, and California does not have either a state estate tax or inheritance tax, so neither his estate nor his inheritors will owe any taxes.

Strategies for Avoiding Death Taxes

If you are working on your estate plan and are interested in ways to minimize or avoid taxes, consult an experienced estate planning attorney. The subject of avoiding estate taxes has spawned entire books and industries, but very briefly, tax avoidance strategies might include:

• Giving away property during your lifetime by taking advantage of the annual exclusion ($15,000 in 2021 and $16,000 in 2022) for gifts each year
• Transferring ownership of your life insurance policy to someone else
• Creatingؙ—with the help of an attorney—various types of complex tax-saving trusts, and
• If you spend significant time in two or more states, considering whether and how to establish legal residence in the state with the least onerous estate or inheritance taxes.

If you are handling or administering an estate that is likely to owe estate taxes, seek expert help from a tax lawyer. Estate tax returns are complicated, and the laws are in constant flux.