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How Inheritance Tax Works


Inheritance Tax Exemptions
If you're the spouse of the unfortunately deceased owner of this home, you're in for a bit of a shock.
If you're the spouse of the unfortunately deceased owner of this home, you're in for a bit of a shock.
Tim Kitchen/Getty Images

There are quite a few ways to avoid or reduce inheritance and estate taxes. Some of them involve very complicated financial structures and maneuvers. If you're the type of person who has tens or hundreds of millions of dollars of estate value to worry about, you're going to hire a skilled estate planner to deal with these things. Basically, an estate planner will work with the family and utilize trusts, charitable donations, non-taxable gifts and other techniques to meet the family's needs and minimize the tax burden.

For smaller estates, exemptions fall into two main categories: exemptions due to the heir's relationship with the deceased and amount-based exemptions. In either case, the exemptions are applied to the taxable amount before the government's percentage comes out. That means that an estate tax can use each exemption just once (because it's only taxed once), while exemptions to inheritance taxes are applied separately to each heir, and can differ from heir to heir.

The most common relationship-based exemption is when the estate is passed from the deceased person to a spouse. In that case, there is an unlimited exemption -- no matter the value of the estate, it will not be subject to federal estate tax if it's passed to a spouse. States who levy an estate tax follow the federal government's rules for this as well. If the estate is passed to children, siblings or golfing buddies, the exemption doesn't apply.

Amount-based exemptions are where things get sticky. For federal estate taxes, the current limit (as of 2011) is $5 million for an individual, $10 million for a couple. If the estate is worth that much or less, no estate tax is levied. This is why estate planners work so hard to move money around -- if they shrink it down to $5 million or less, the estate is tax free. This is also why estate taxes are considered a tax on the rich, because really, how many of us are losing sleep over what happens to someone's $20 million estate?

State inheritance taxes make things more complicated. Each state uses different thresholds (if it has inheritance taxes at all). There might be exemptions for some family members, but not others, or different tax rates depending on whether you're a spouse, a child or just a friend. Many states tie their inheritance tax directly to the federal estate tax and exemption rate. Some have much lower thresholds than the federal threshold. In Illinois, for example, the threshold is only $2 million, while in Hawaii it's $3.5 million (as of 2011) [source: McGuireWoods].

There are a few other miscellaneous deductions, usually deducted from the estate's value before taxation. If a property is mortgaged, the amount of the mortgage is deductable. Also, family business and farms may be taxed at a reduced rate. This allows families to pass business down to the children without the business going bankrupt.

Next, we'll talk numbers and specific tax rates.


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