Estate Planning: What are the differences between the Estate and Inheritance Tax?
1. Taxpayer
The primary difference between estate tax and inheritance tax lies in who is responsible for paying the tax. The estate tax is levied on the estate itself, meaning that the tax is paid out of the deceased person's estate before the assets are distributed to the beneficiaries. In contrast, inheritance tax is imposed on the beneficiaries who receive the inheritance. Each beneficiary is responsible for paying inheritance tax on the value of the assets they inherit, depending on their relationship to the deceased and the size of their inheritance. This fundamental difference in taxpayer responsibility is the key distinction between the two types of taxes.
2. Tax Basis
The basis on which estate tax and inheritance tax are calculated also differs. Estate tax is calculated on the total value of the deceased person's estate at the time of their death, including all assets such as real estate, investments, and personal property. The estate's value is assessed as a whole, and the tax is applied to the estate's total value before any distributions are made. Inheritance tax, on the other hand, is calculated based on the value of the specific assets each beneficiary receives. The tax is applied to each individual inheritance, with rates that may vary depending on the beneficiary's relationship to the deceased and the value of the inheritance.
3. Federal vs. State Tax
Another key difference is that the estate tax is primarily a federal tax, while inheritance tax is typically imposed at the state level. The federal government imposes an estate tax on estates that exceed a certain threshold (known as the estate tax exemption). Some states also impose their own estate taxes, which can vary in terms of exemption levels and tax rates. Inheritance tax, however, is not imposed by the federal government and is only levied by a handful of states. The rules, exemptions, and rates for inheritance tax can vary widely from state to state, making it important for beneficiaries to understand the specific laws in their state.
4. Exemptions and Thresholds
The exemptions and thresholds for estate tax and inheritance tax differ significantly. For estate tax, the federal government sets a relatively high exemption level, meaning that only estates exceeding this threshold are subject to the tax. As of 2024, the federal estate tax exemption is $12.92 million per individual, which effectively means that most estates are not subject to federal estate tax. In contrast, inheritance tax exemptions and thresholds are typically lower and vary by state. Some states may offer exemptions based on the beneficiary's relationship to the deceased (e.g., spouses or children may receive a full or partial exemption), while others may apply a flat rate regardless of the relationship.
5. Impact on Beneficiaries
The impact of estate tax and inheritance tax on beneficiaries can differ significantly. With estate tax, beneficiaries receive their inheritance after the tax has been paid by the estate, meaning they do not have to worry about additional tax liabilities. However, the overall size of their inheritance may be reduced due to the estate tax. With inheritance tax, beneficiaries must calculate and pay the tax themselves, which can complicate the process of receiving and managing their inheritance. The amount of inheritance tax owed can vary depending on the size of the inheritance and the beneficiary's relationship to the deceased, which may create additional financial planning considerations for the beneficiaries.
6. Applicability to Non-Family Members
Estate tax and inheritance tax can differ in how they apply to non-family members. Estate tax applies to the entire estate, regardless of who the beneficiaries are, meaning that all assets are taxed before distribution, whether they are going to family members or non-family members. Inheritance tax, however, often differentiates between family members and non-family members, with non-family members typically facing higher tax rates and lower exemptions. For example, in some states, close relatives such as spouses and children may be exempt from inheritance tax or pay lower rates, while non-family members may be subject to higher taxes on their inheritance.
7. Portability
Portability refers to the ability to transfer unused tax exemptions from one spouse to another. This concept is relevant to estate tax but not to inheritance tax. In the case of estate tax, the federal government allows for "portability" of the estate tax exemption between spouses. This means that if one spouse does not use their entire exemption amount, the surviving spouse can add the unused portion to their own exemption, effectively doubling the amount that can be passed on tax-free. Inheritance tax, being imposed at the state level, does not typically offer portability of exemptions, meaning each beneficiary is taxed individually based on the value of their inheritance.
8. Charitable Deductions
Charitable deductions can impact how estate tax and inheritance tax are calculated. For estate tax purposes, the value of assets left to qualified charities is deductible from the estate's total value, reducing the overall estate tax liability. This allows individuals to minimize estate tax by making charitable bequests. Inheritance tax, on the other hand, does not directly account for charitable deductions, as the tax is calculated on the value of the assets received by each beneficiary. However, if a beneficiary chooses to donate their inheritance to charity, they may be able to claim a charitable deduction on their individual income tax return, depending on the specific tax laws.
9. Timing of Tax Payment
The timing of tax payment differs between estate tax and inheritance tax. Estate tax is typically due within nine months of the deceased person's death, and the estate's executor is responsible for filing the necessary tax returns and paying the tax. The estate tax must be paid before the assets can be distributed to the beneficiaries. Inheritance tax, on the other hand, is paid by the beneficiaries after they receive their inheritance. The timing of inheritance tax payment varies by state, but beneficiaries are generally required to pay the tax within a certain period after receiving the inheritance. This difference in timing can affect how and when beneficiaries receive their inheritance.
10. Tax Planning Strategies
The strategies used for estate tax planning and inheritance tax planning can differ based on the nature of the taxes. Estate tax planning often involves strategies to reduce the overall value of the taxable estate, such as gifting assets during the individual's lifetime, creating irrevocable trusts, or making charitable donations. The goal is to minimize the estate tax liability before the individual's death. Inheritance tax planning, on the other hand, may focus on structuring the inheritance to minimize the tax burden on beneficiaries, such as by using life insurance policies, creating family trusts, or taking advantage of state-specific exemptions and deductions. The different approaches to tax planning reflect the unique characteristics and implications of each tax.
