As of 2015, you can have an estate worth up to $5.43 million before you need to worry about federal estate taxes taking a bite out of the money and other assets you leave to your heirs.
Therein lies the problem.
If taxpayers stop worrying about death tax planning altogether, their heirs could be in for an unpleasant surprise after they die. The heirs or the estate may owe a considerable amount of money to the state, even if they don’t owe a penny of federal estate tax.
In many cases, the state tax could have been avoided with more careful planning.
The difference between estate taxes and inheritance taxes
The main difference between estate taxes and inheritance taxes is who pays the tax. The clue is in the name.
Estate taxes are paid by the deceased person’s estate before the money is distributed to their heirs.
Inheritance taxes are paid by the person inheriting the money or assets.
The federal government levies an estate tax, although few taxpayers actually owe federal estate tax. That’s because a filing is required for estates with combined gross assets and prior taxable gifts in excess of $5.43 million in 2015.
Fifteen states and the District of Columbia also have an estate tax. As with the federal estate tax, the state estate tax is paid before you receive any inheritance.
On the other hand, six states have an inheritance tax. These states are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. (Maryland and New Jersey have both estate and inheritance taxes.)
Because the estate tax is calculated on the estate, it doesn’t matter who the beneficiaries of the estate are after the estate is reduced by the property received by the deceased person’s spouse.
For inheritance taxes, however, the relationship between the person who died and the beneficiaries matters a great deal.
The widow or widower of the deceased is completely exempt from inheritance tax, and children pay no or a reduced rate of inheritance tax. Other relatives may also pay reduced rates and only on the inheritance over a threshold amount.
Who is responsible for filing estate and inheritance tax returns?
The executor of an estate needs to file one federal estate tax return and one state estate tax return, if necessary. The executor pays the tax from the estate funds.
The executor also files a state inheritance tax return for the estate, if they live in a state that has an inheritance tax and reports the amount each beneficiary receives.
The amount of inheritance tax each beneficiary must pay is also calculated on this form.
How can I avoid paying state inheritance taxes?
The most obvious way to avoid paying state inheritance taxes is to make sure you live in a state that doesn’t have them when you die. That’s not practical or necessary for many people.
However, if you already split your time between two states, you may want to make sure you can claim the state without an inheritance tax as your residence when you die. (The sunny weather isn’t the only reason so many people call Florida their home!)
You may be able to reduce the amount of inheritance tax you owe by transferring assets before you die, selecting beneficiaries who will pay little or no inheritance tax (such as your spouse, children, and close relatives), or setting up various types of trusts.
If you have substantial assets and you’re worried about state inheritance taxes, seek professional legal advice in your state. A little attention now may save your heirs a considerable amount of money – and frustration – when they inherit your estate.