How Inheritance Tax Works

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Introduction to How Inheritance Tax Works

Death tax. Estate tax. Inheritance tax. People refer to it by many names, and opinions on its morality and constitutionality abound.

Opponents of inheritance tax -- who sometimes call it “death tax” -- say it’s immoral to place a financial burden on a family that has just suffered the loss of a loved one.

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The College Republicans National Committee protests the federal estate tax in Washington, D.C., on June 8, 2006.
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Proponents say that death taxes are good sources of revenue for governments because the taxes apply only to the wealthy. In an inheritance, money passes from one party to another, and supporters say this money should be taxed, just like income or taxable gifts.

But what is inheritance tax? Is it different from estate tax? Why is there a tax on death? And how does this "death tax" work?

Indeed, as you will find out on the following pages, inheritance tax is not the same as estate tax, though they do share some similarities and follow some comparable procedures. Inheritances are subject to some tax exemptions. And though inheritance tax rates can be high, they work in different ways depending on the inheritance and the state you live in.

First, take a look at the differences between inheritance tax and estate tax.

Differences Between Estate Taxes and Inheritance Taxes

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Senator Trent Lott discusses the estate tax at a news conference in Washington, D.C., on June 8, 2006.

The primary differences between inheritance tax and estate tax are where the tax burden falls -- that is, whether it must be paid by an individual heir, or by the estate itself -- and to whom the tax is paid.

In the United States, inheritance tax is levied by the state. In recent years, however, many states have repealed or phased out their inheritance taxes.

The U.S. federal government levies the estate tax. However, the Economic Growth and Tax Relief Reconciliation Act of 2001 has been phasing out the estate tax, and is set to repeal it in 2010. Oddly, in 2011 the tax will rise from the dead. The U.S. Congress continues to debate the final fate of the estate tax.

Inheritance tax is a tax on the money and assets received by a beneficiary (also called a transferee or heir) from the estate of the decedent (the person who died). The estate is the grand total of everything the decedent owned and had interests in (business investments, for example) at the time of death. Beneficiaries must pay taxes on the value of whatever they inherit, though they can claim a number of exemptions to reduce these taxes.

The inheritance tax rate depends primarily on the type of property being inherited and the relationship of the heir to the decedent. For example, when Mr. Smith dies, he leaves his mansion and fortune to his children, his fancy car collection to his brother Ralph and his yacht to his old fishing buddy Terrance. Usually, each child must pay taxes on what he or she inherits.

Ralph must pay taxes on the car collection. He will probably be taxed at a higher rate than Mr. Smith's children because he is not a lineal descendant or ancestor -- not a child or parent of the deceased. Non-lineal heirs are generally subject to higher inheritance taxes.

Terrance must pay the most taxes, as he is the most distantly related heir -- just a friend.

Death Taxes Around the WorldMost countries don't have an estate tax but do levy an inheritance tax [source: Tax Policy Center].

Estate tax is a tax on the total value of the money and assets left behind by a decedent. Whereas heirs are responsible for paying inheritance taxes, the estate's executor or administrator (the person responsible for handling the affairs of the estate, as directed in the decedent's will) must pay the estate tax. After various exemptions are applied, the executor uses money from the estate itself to pay the tax.

The estate tax rate depends on the overall value of the estate. Usually, appraisers assess the fair market value of the estate's assets and interests to come up with the overall value of the estate.

For example, appraisers declare that Mr. Smith's estate is worth $10 million. This is the total of Mr. Smith's checking account, his mansion and land, his car collection, his yacht and his shares of stock. The executor is responsible for paying the federal estate tax on the $10 million value. He or she uses the estate's holdings -- cash, real estate, stocks, trusts, business investments, et cetera -- to pay the tax. This tax is assessed before the heirs receive their inheritances. The federal government gets its money before anyone else.

Next we'll examine the various inheritance tax exemptions the lucky heirs can claim.

Inheritance Tax Exemptions

An inheritance tax exemption is a deduction that reduces the taxable value of the inheritance. Just as you can claim deductions on your federal income tax return, you can claim deductions when you receive an inheritance.

In practice, when you claim an exemption on inheritance tax, you reduce how much inheritance tax you will pay. And while inheritance tax exemptions vary from state to state, they're based on the same principles.

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In 2006, attorney Howard Stern guided Anna Nicole Smith through a legal case concerning Smith's deceased
husband's estate.

With estate tax, the estate gets only so many deductions, but with inheritance tax each heir can claim exemptions. So, continuing with our example, each of Mr. Smith's children can claim various exemptions. Ralph can claim exemptions. Terrance can claim exemptions.

The relationship of the heir to the decedent affects the exemptions the heir can claim. The most important relationship exemption is the one the decedent's surviving spouse can claim. Anything the decedent leaves to his surviving spouse is tax-exempt. So, if Mr. Smith left his wife his entire estate, Mrs. Smith would not have to pay a dime of inheritance tax (or estate tax, for that matter).

But if a state considers an heir a close family member of the decedent's, the heir may qualify for a family exemption. Pennsylvania, for example, has a $3,500 family exemption. Heirs outside Mr. Smith's family, such as Terrance, would not be able to claim this exemption.

The biggest exemption a non-spouse heir can claim on inheritance tax is the state's minimum tax threshold. If the value of the inheritance is less than a specified amount, the heir does not have to pay inheritance tax. In Tennessee, for example, if an heir's inheritance is less than $1 million, he or she does not have to pay inheritance tax.

Cheating DeathCrafty estate planners have figured out many ways to use estate and inheritance tax exemptions to reduce their clients' taxes. One popular route is to create trusts upon death, bequeath some money to charity, bequeath a chunk equal to the tax threshold to children and leave the rest to one's spouse. With recent increases in the tax thresholds for estate and inheritance taxes, heirs are able to avoid having to pay increasingly large amounts of money.

Money and assets, including real estate, left to a charity or other organization are subject to different tax rates. In some states, such as Pennsylvania, anything bequeathed to charity is tax-exempt.

In most states, heirs can deduct any insurance benefits they receive from the decedent's estate. For example, if Mr. Smith's life insurance policy pays out $250,000, and his children Timothy and Belinda are equal beneficiaries on the policy, Timothy and Belinda could each claim $125,000 of the estate tax free.

If the decedent already paid taxes on certain types of property, the heirs usually don't have to pay additional taxes.

So after the exemptions are accounted for, how much would you possibly have to pay? Read on to find out about the rates behind inheritance taxes.

Inheritance Tax Rates

Inheritance and estate taxes tend to be fairly high, which is one of the reasons controversy surrounds them. The exact rates vary from state to state, but inheritance taxes tend to be set up on a progressive scale. The more valuable the estate, the higher the tax rate.

How do you know what your inheritance tax rate will be?

You must find out the total appraised value of your inheritance.
Apply any exemptions you can claim.
Find the tax bracket for your inheritance.

The tax bracket for your inheritance depends on your relationship to the decedent. Whether your state considers you a beneficiary, an heir or a transferee, the state will classify you according to your relationship to the decedent. Which class you fall into determines your tax rate. Remember, surviving spouses are completely exempt from inheritance tax.

For example, Pennsylvania has the following basic tax rates:

4.5 percent for lineal descendants
12 percent for siblings
15 percent for anyone else [source: Law Offices of Robert Clofine]

This means that Mr. Smith's children and grandchildren have to pay 4.5 percent of the value of their inheritance (after exemptions). Mr. Smith's brother Ralph has to pay 12 percent. Mr. Smith's fishing buddy Terrance would pay 15 percent.

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In the summer of 2006, then-Senate Majority Leader Bill Frist, R-Tenn., discussed the federal estate tax with an aide.

For a more nitty-gritty example, let's take a look at Indiana's inheritance tax system.

Indiana divides heirs into three classes. Each class has a different tax rate schedule and exemption.

Class A ($100,000 exemption): direct ancestor or descendant, stepchild, direct descendant of stepchild (stepchild doesn't need to be adopted)
Class B ($500 exemption): sibling (brother or sister); descendant of sibling; spouse, widow or widower of your child
Class C ($100 exemption): anyone else, besides your spouse [source: Indiana Department of Revenue]

Mr. Smith's children Timothy and Belinda would be Class A heirs. Let's say Timothy and Belinda each inherit $450,000 in cash. Because they are Class A heirs, each can claim a $100,000 exemption, reducing their taxable inheritance to $350,000 apiece. Now, let's see what their tax rate will be.

inheritance of $25,000 or less: 1 percent of net taxable value
over $25,000 but not over $50,000: $250, plus 2 percent of net taxable value over $25,000
over $50,000 but not over $200,000: $750, plus 3 percent of net taxable value over $50,000
over $200,000 but not over $300,000: $5,250, plus 4 percent of net taxable value over $200,000
over $300,000 but not over $500,000: $9,250, plus 5 percent of net taxable value over $300,000 [source: Indiana Department of Revenue]

Belinda and Timothy are in the fifth marginal tax rate for the Indiana inheritance tax. This means that their first $25,000 will be taxed at 1 percent, their second $25,000 ($25,001 to $50,000) will be taxed at 2 percent, and so on. When their income reaches the fifth bracket, they have a remaining $49,999 that will be taxed at the 5 percent rate. The calculation will look like this:

$49,999 x 0.05 = $2,499

To find their total tax, add the tax from the fifth bracket to the tax accumulated in the lower tax brackets.

$2,499 + $9,250 = $11,749.95

So, Timothy and Belinda each owe $11,749.95 in inheritance tax. Since Departments of Revenue prefer to round their figures, Timothy and Belinda will pay $11,750 each.

Each state has their own rates they charge. And of course, there's also the federal tax rate, which is much higher. For 2007-2009, the federal estate tax rate is 45 percent of the total inheritance. $11,750 doesn't seem like a lot of money anymore does it?

To learn more about inheritance tax and related topics, you can follow the links on the next page.

Pick-Up TaxesMost inheritance taxes in the United States have vanished because their state governments set the taxes up as "pick-up" taxes. These taxes were dependent on and determined by the size of the federal estate tax levied. As the federal estate tax has decreased since 2001, states found themselves unable to levy any inheritance tax. These states phased out their inheritance tax, repealed the tax altogether or established a new inheritance or estate tax independent of the federal estate tax.

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