Estate Tax vs. Inheritance Tax: What’s the Difference?

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While it’s not exactly fun to financially plan for dying one day, it’s better than leaving your loved ones unprotected. Whether it’s an inheritance or an estate, you want to leave them in the best possible place.

Understanding the difference between estate tax and inheritance tax is a good idea for anyone planning their financial future. Paying taxes is the only inevitability outside of death but can significantly impact what you leave behind for your loved ones.

It’s important to know that they work in different ways. Here are some key differences when comparing estate and inheritance taxes: 

• The estate pays estate tax before assets are distributed, while inheritance tax is paid by the beneficiaries who receive the inheritance.
• Estate tax is based on the total value of the deceased’s estate, whereas inheritance tax is based on the value of individual inheritances.
• The federal government imposes an estate tax but not an inheritance tax; some states impose an inheritance tax.
• The federal estate tax has a high exemption threshold, exempting most estates from taxation. Inheritance tax exemptions vary by state and often depend on the relationship between the deceased and the beneficiary.

Here’s a quick look at how estate and inheritance taxes work differently and impact your finances.

Quick Take: What Is Estate Tax?

The estate tax, sometimes referred to as the “death tax,” is a tax on the total value of a person’s estate before it’s distributed to their heirs. This means that the tax is calculated based on the entire estate, including all property, investments and other assets, minus any debts and expenses.

It’s important to know the state estate tax is levied by the estate itself, not by the beneficiaries who receive the inheritance. Estate tax exemptions can be assessed separately, but federal and state estate taxes are paid from the assets of your estate before the remaining assets can be distributed to your heirs after the date of death.

Here are some key takeaways:

• Paying estate taxes: In the United States, the federal estate tax only applies to estates exceeding a certain value, which as of 2024, is $13.6 million. Simply put, if your estate is worth less than this amount, you won’t owe any federal estate tax. Some states also have their own estate taxes, with varying exemption thresholds and tax rates.
• Calculating estate taxes: The estate tax is calculated on a graduated scale, meaning that the tax rate increases as the value of the estate increases. For example, the federal estate tax rate ranges from 18% to 40%, depending on the estate’s value.
• Estate planning strategies: You can gift your assets during your lifetime or set up trusts, which can help reduce the taxable value of your estate and keep your loved ones from having to pay more than they should 

Quick Take: What Is Inheritance Tax?

Inheritance tax is a tax on the beneficiaries who receive assets from an estate such as real estate or money. Unlike the estate tax, which is paid by the estate before distribution, inheritance tax is paid by the individuals who inherit the property or money. The tax rate can vary based on the beneficiary’s relationship to the deceased and the amount they inherit.

• Paying inheritance tax: Only a few states in the U.S. impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. Each state has different rules and exemption amounts.
• Inheritance tax rates: Generally, close relatives like spouses and children either pay a lower rate or are exempt from the tax altogether, while more distant relatives and unrelated individuals could pay higher rates.
• Calculating inheritance tax: The calculation of inheritance tax depends on the state’s specific laws and the beneficiary’s relationship to the deceased. For instance, in Pennsylvania, direct descendants (children, grandchildren) pay a 4.5% tax, siblings pay 12% and more distant heirs or unrelated inheritors pay 15%.
• Inheritance tax exemptions: Some states also provide exemptions up to a certain amount, meaning only the inheritance exceeding that amount is taxed.

Final Take To GO: How To Reduce Tax Impact

The bottom line is that while both estate tax and inheritance tax can affect the legacy you leave behind, understanding the differences can help you make informed decisions about your estate planning.

By taking proactive steps and seeking professional guidance, you can minimize the tax burden on your heirs and ensure that your assets are distributed according to your wishes. Here are some ways you can reduce your tax impact on your loved ones:

• You can give away a portion of your estate as gifts during your lifetime. The annual gift tax exclusion allows you to give up to $18,000 per person (as of 2024) without incurring gift tax.
• Establishing trusts can help manage your estate and potentially reduce estate taxes. Trusts can also provide control over how and when your assets are distributed.
• Proceeds from life insurance policies are generally not subject to estate tax if the policy is structured correctly.
• Consulting with an estate planning attorney or financial advisor can help you develop strategies tailored to your specific situation and ensure that you comply with all relevant laws.

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