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How Inheritance Tax Works

By: Ed Grabianowski & John Barrymore

Inheritance Tax Rates

Exact inheritance tax rates vary from state to state, but inheritance taxes tend to be set up on a progressive scale. The general rule: The more valuable the estate, the higher the tax rate.

How do you know what your inheritance tax rate will be? The tax bracket for your inheritance depends on your relationship to the deceased. Remember, surviving spouses are completely exempt from inheritance tax. Also, keep in mind that state tax laws do change, so the specific numbers in the following examples may shift over the years.

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Pennsylvania has the following basic tax rates:

For another 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]

Let's imagine a fictional family -- Mr. Smith is a widower with two children, Belinda and Timothy. Mr. Smith's children would be Class A heirs. Let's say they 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.

Federal estate tax law has undergone some big changes in recent years. In 2010, there was no federal estate tax. However, inheritances were taxed as capital gains, the same as profits from stocks, bonds and real estate. But at the end of 2010, President Obama signed the December 2010 Tax Relief Act. It re-established the federal estate tax at a rate of 35 percent, but with the $5 million exemption. That exemption, by the way, means that only 0.5 percent of all estates in the U.S. will pay any estate taxes at all [source: Randolph]. Those tax rates and exemption thresholds expire at the end of 2012, when Congress will decide on a new rate.

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

Inheritance Taxes FAQ

Do you have to report inheritance money to IRS?
You do not have to report inheritance money to the IRS on your federal tax return.
How much can you inherit before paying inheritance tax?
This varies from state to state. Because inheritance tax is a state tax, the state you reside in will set the tax percentage or amount.
Do beneficiaries pay taxes on inherited money?
If your state has an inheritance tax, then you may have to pay taxes on any money you inherit. There are six states that have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
What states have no inheritance tax?
All but six states have zero inheritance tax. The six states that do charge this tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
What is the difference between estate tax and inheritance tax?
An estate tax is a federal tax on the total value of the property owned by someone who dies. The estate, or the property left behind, pays this tax. An inheritance tax, on the other hand, is a state tax that's paid by someone who receives inherited property.

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Sources

  • Elder Law Firm of Robert Clofine. "Pennsylvania Inheritance Tax." (Accessed July 1, 2011)http://www.estateattorney.com/elderlaw-articles/taxes-pit-inheritancetax.html
  • Indiana Department of Revenue. "IC 6-4.1-5-1 Tax rates; transfers to Classes A, B, and C transferees." (Accessed July 1, 2011) http://www.in.gov/legislative/ic/code/title6/ar4.1/ch5.html
  • Indiana Department of Revenue. "Indiana Inheritance Tax Information." http://www.in.gov/dor/3807.htm
  • Internet Revenue Service. "Estate Tax." (Accessed June 20, 2011.) http://www.irs.gov/businesses/small/article/0,,id=164871,00.html
  • McGuireWoods. "2011 State Death Tax Chart." (Accessed June 22, 2011.) http://www.irs.gov/businesses/small/article/0,,id=164871,00.html
  • Randolph, Mary. "Estate Tax: 2011 Tax Law Has New Rules for 2010 Deaths." NOLO, (Accessed June 22, 2011.) http://www.nolo.com/legal-encyclopedia/estate-tax-2011-tax-law-32263.html
  • Sullivan, Paul. "Wealthy Hesitate to Take a Break on Estate Taxes." New York Times, May 13, 2011. (Accessed June 21, 2011.) http://www.nytimes.com/2011/05/14/your-money/taxes/14wealth.html?_r=1&ref=estateplanning