Generally, when planning your estate in 2021, you don’t have to worry about federal “death taxes’ unless it’s valued at $11.7 million or more ($23.4 million for married couples). Currently, only a tiny percentage of U.S. taxpayers would end up paying between 18% and 40% on any excess. You also don’t have to worry about a federal inheritance tax being levied on your heirs because most inheritance is not considered income for tax purposes at the national level.
But just because the value of your estate is low enough to escape any federal estate taxes, it doesn’t mean your heirs are in the clear. Your state might still want a piece of it. Currently, 12 states and the District of Columbia levy an estate tax, and six states impose an inheritance tax. Maryland imposes both taxes.
Most people understand how the estate tax works. Like the federal government, estate taxes levied by the states are paid by the estate on the value of your assets that exceed exemptions. Less understood are the inheritance taxes imposed by states that the heirs pay on the value of the property they receive.
The six states that levy an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
How the Inheritance Tax Works
While each state establishes its own rules for inheritance tax collection, the amount of tax your heirs will owe, if any, depends on how closely related they are to you, the size of the inheritance, and whether your state offers any exemptions. Generally, immediate family members are exempt from inheritance taxes.
The key factor in determining how and whether an inheritance tax is applied is the state of residency of the decedent and the heirs. For example, if you live in Iowa, which does have an inheritance tax, and you leave assets to your nephew who lives in Arizona where there is no inheritance tax, your nephew would owe Iowa a tax.
However, if you live in Arizona and your nephew lives in Iowa, he would not owe Arizona a tax because it doesn’t have an inheritance tax. The one situation in which your nephew could owe a tax is if you are an Arizona resident and you left him some property located in Iowa, where he lives. If, instead you left property you owned in Arizona, he would not owe an inheritance tax.
Who Pays the Tax?
The other determining factor is your relationship with your heirs. For instance, all six states exempt surviving spouses from their inheritance tax. Domestic partners are exempt in New Jersey, and Maryland exempts jointly held primary residences left to domestic partners. In four of the states, direct descendants, such as children and grandchildren, are not taxed. Nebraska and Pennsylvania impose a tax on some immediate relatives but at a substantially lower rate or with exceptions.
How is the Inheritance Tax Calculated?
Also, most of the states apply thresholds below which inheritances are not subject to the tax. For example, if the threshold, or exemption amount, is $40,000 and an heir receives $100,000, the tax is paid on $60,000.
In most of the states, a higher rate is applied to higher estate values as well as non-exempt relatives, such as siblings, cousins, in-laws, uncles, aunts, nephews, and nieces. The highest rates are applied to nonrelatives, such as charitable organizations.
Here’s the breakdown of state inheritance tax rates for 2021, ranging from closest relatives to non-exempt relatives to nonrelatives:
|Iowa||5% to 15%|
|Kentucky||4% to 16%|
|Nebraska||1% to 18%|
|New Jersey||11% to 16%|
|Pennsylvania||4.5% to 15%|
Individual State Notes
- Inheritance taxes are not levied on estates valued at less than $25,000.
- All lineal ascendants and descendants are exempt.
- Direct descendants such as spouses, parents, children, grandchildren, and siblings are exempt.
- The first $1,000 of property is exempt for other related heirs.
- Kentucky permits a 5% discount to those who pay their inheritance tax within nine months of the date of the decedent’s death.
Maryland is the only state with a flat tax rate (10%).
- The list of heirs exempt from paying the tax is extensive, including spouses, parents, grandparents, children, grandchildren, siblings, sons- and daughters-in-law), and surviving spouses of a deceased child.
- Nebraska has the highest inheritance tax.
- No relationships are exempt; however, immediate relatives are only taxed at a 1% rate.
- The exemption amount for immediate relatives is $40,000 but drops to $10,000 for extended relatives who pay a 13% tax.
- Life insurance passed through the estate is taxed under Nebraska’s inheritance tax rules.
- Spouses, domestic partners, parents, grandparents, children, and their descendants, and stepchildren are exempt.
- Siblings, sons- and daughters-in-law pay tax rates ranging from 11% to 16% on assets above $25,000.
- Pennsylvania doesn’t tax spouses, parents of descendants aged 21 or younger, or children aged 21 or younger.
- Parents of decedents older than 21, grandparents, lineal descendants, sons- and daughters-in-law are taxes at a 4.5% rate.
- All other relatives are taxed at a 15% rate.
Planning Can Ease the Inheritance Tax Bite
For people who do proper estate planning, the inheritance tax is typically paid by the estate, so heirs don’t have to write a check. A well-conceived estate plan can also employ tools and strategies that can minimize the tax in some cases. Utilizing gift tax exemptions, charitable giving strategies, life insurance trusts, and other trust arrangements can help to maximize the inheritance for your heirs.
If subjecting your heirs to an inheritance tax is a concern, your first step should be to meet with a qualified tax advisor to consider all your options. Dechtman Wealth can work with you to ensure as much as your gift is paid to your beneficiary as possible.
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