Differences Between Estate Taxes and Inheritance Taxes

Before we start, let's clear up some confusion about terminology. While "estate tax" and "inheritance tax" are distinct terms with separate legal meanings, those meanings differ from country to country. Sometimes, the terms are used interchangeably. You might also hear a pundit of commentator on TV talking about a "death tax." That term can refer to either estate or inheritance tax, depending on the situation. The definitions in this article are generally accurate in the U.S. and in international law, although even some U.S. states muddle the terms.

Let's start with estate tax. Your estate is the total of your possessions and debts left behind when you die. An executor, either named in the will or appointed by law, is placed in charge of the estate and must pay off outstanding debts, liquidating property to do so if necessary. Funeral expenses and administrative costs (that is, payment to the executor for dealing with all of this) are taken out next. Whatever is left over is what can be passed on, but before that happens, the federal government takes its share. In 2010, the maximum rate was 35 percent; a few states levy an estate tax as well. So, the estate tax is a tax on the total amount of the estate, after creditors are paid but before any heirs get their bequest. The tax is paid by the estate itself.

Inheritance tax occurs after the heirs have received their payouts from rich Uncle Thaddeus. It is a tax on the amount received and is paid by the heir. Inheritance taxes are levied by the states. This means that in many cases an estate is taxed twice -- first by the federal estate tax, then by the state inheritance tax.

What exactly counts toward the estate, anyway? Is it just the money stashed under the bed? The bank account? The summer home in the Maldives? An estate is all of those things, and more: Cash, accounts, real estate, stocks and bonds and other business interests, and valuable goods like cars, boats, art pieces or rare collections. An appraiser will determine the fair market value of everything to figure out the taxable value of the estate.

So far, for anyone who dies and wants to leave anything of value to his or her heirs, things look pretty grim. There's a bright spot, though -- exemptions that reduce the taxable amount. We'll discuss that next.