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 In recent years, however, many states have repealed or phased out their inheritance taxes.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.

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.