The Differences Between Estate and Inheritance Taxes

While inher­i­tance tax and estate tax are both referred to as “death taxes,” they are two distinct taxes. Estate tax is levied against someone’s estate upon death and is based on the size of the total estate. Inher­i­tance tax is levied against the heirs of an estate. The amount of inher­i­tance tax can depend not only on the size of the inher­i­tance, but also on the heir’s relationship with the deceased.

The federal government collects an estate tax, along with 12 states and the District of Columbia.

States with an Estate Tax

Most people are probably aware of the federal estate tax. It is charged to a decedent’s estate when their assets pass on to their benefi­ciaries. Currently, most estates do not pay the federal estate tax, since it only applies to estates worth more than $11.7 million (as of 2021). An estate tax is calcu­lated based on the net value of property owned by a deceased person on the date of death. The federal estate tax rate varies, but it can be as high as 40% of the amount of the estate that exceeds the exclusion.

All state-levied estate taxes provide exemp­tions up to a certain level and tax the estate’s value above that exemption.

An inher­i­tance tax is calcu­lated based on who receives a deceased person’s property and, in some states, how much they receive. There are currently six states that collect an inher­i­tance tax. In all six, transfers to surviving spouses are entirely exempt from the tax. In four states—Iowa, Kentucky, Maryland, and New Jersey—transfers to surviving children and grand­children are also exempt from the tax.

The rates for Pennsyl­vania inher­i­tance tax are as follows:

• 0% on transfers to a surviving spouse or a parent from a child aged 21 or younger
• 4.5% on transfers to direct descen­dants and lineal heirs
• 12% on transfers to siblings
• 15% on transfers to other heirs, except chari­table organi­za­tions and exempt insti­tu­tions or government entities

Inher­i­tance tax payments are due upon the decedent’s death and become delin­quent nine months after the individ­ual’s death. If inher­i­tance tax is paid within three months of the decedent’s death, a 5% discount is often allowed.

Currently, six states collect an inher­i­tance tax.

Inheritance Tax

Let’s look at an example of how all of this can work. Bill and Ray decided that to be finan­cially successful, they would need to become business owners. Both had experience in the hospi­tality industry, and they pooled their money to jointly purchase a property just outside of town and open a restaurant.

In their 23rd year of operating their restaurant, Ray passed away unexpectedly. Bill and Ray had paid off their debt and named each other as heir in their wills. Bill assumed it would be a simple matter of changing the property title solely to his name and deciding what to do with the business later. That was before he learned about Pennsylvania’s inher­i­tance tax.

Pennsyl­va­nia’s inher­i­tance tax applies to all real estate and tangible personal property (such as furniture, vehicles, jewelry, etc.) located in Pennsyl­vania, whether Pennsyl­vania residents or non-residents own the property. It also applies to all intan­gible property of Pennsyl­vania residents (bank accounts, stocks, bonds, mutual funds, and patents, etc.). Because Pennsyl­vania inher­i­tance tax will apply to all intan­gible property of a Pennsyl­vania resident no matter where the property is “located,” simply opening a joint account with a bank in another state will not avoid Pennsyl­vania inher­i­tance tax.

For Bill, it’s unfor­tunate that jointly titled property owned by unmarried partners who reside in Pennsyl­vania is almost always subject to inher­i­tance tax upon the death of one of the partners. Bill was surprised to find out that the real estate was now worth $1.8 million. The restaurant business appraised at $500,000. Their joint ownership meant that half of the value ($1,150,000) would be included in Ray’s estate. Ray also had $300,000 in a retirement account for which he had named Bill as the beneficiary.

Ray’s $1,450,000 estate was below the federal estate-tax exemption. However, because he left the estate to a non-relative, it incurred a $217,500 Pennsyl­vania inher­i­tance tax bill. The property would need to be sold or mortgaged to pay the tax. Bill could take money out of the retirement account to pay Pennsyl­vania. The withdrawal would not be subject to a penalty, but it is taxable as income to Bill. Both options have signif­icant drawbacks.

The future of the inher­i­tance tax in Pennsyl­vania is uncertain. Most states have been moving away from estate or inher­i­tance taxes or have raised their exemption levels. Delaware repealed its estate tax at the beginning of 2018. New Jersey finished phasing out its estate tax recently and now only imposes an inher­i­tance tax. Maryland is the only remaining state that has both an estate tax and an inher­i­tance tax. Pennsyl­vania collected over $117 million from inher­i­tance taxes in July 2021 alone. It will be challenging to eliminate this tax without finding a way to replace the revenue.

An individual’s estate plan should include a provision to deal with estate and inher­i­tance taxes. For example, Ray and Bill could have purchased life insurance on each other to provide cash to pay the tax. An estate planner may have additional strategies to minimize the taxes depending on the situation and state of residency.

Insights

• Estate and inher­i­tance taxes are different ways of levying a death tax.
• The federal estate tax excludes the first $11.7 million of an estate’s value.
• An inher­i­tance tax is calcu­lated based on who receives a deceased person’s property.

Originally posted March 1, 2012