Inheritance Tax: What It Is & How to Avoid It

Short Answer: In 2024, only six states charged inheritance tax, and the number will drop to five in 2025. Find inheritance tax rates and exemptions below. 

An inheritance usually comes with the loss of a loved one, which can mean it's a challenging time. The last thing you want to think about is worrying about taxes. Unfortunately, you'll need to know the tax implications in the state of the bequest and where you live. 

An inheritance can also present a significant windfall for your heirs if you've built generational wealth. Cerulli and Associates say $84.4 trillion in assets will be passed down through 2045. If you’ve just discovered that someone has bequeathed you a home or another type of inheritance, it’s time to learn what it can mean for your taxes. Understanding the process and getting organized are important first steps.

What Is Inheritance Tax?

Inheritance tax is a tax that beneficiaries must pay on assets bequeathed to them upon the death of the owner of those assets. The decedent could be a spouse, parent, sibling, friend, relative, loved one or even an unknown person or entity. In most cases, you could be subject to an inheritance tax if you receive an inheritance. However, how much inheritance tax and the level of inheritance you'll need to pay depends on where the person lives and where you live. 

The tax implications of inheritance differ from those of a windfall you might receive — for instance, taxes are different on a sizable bonus or a Powerball win. The government considers those as ordinary income for tax purposes, and you may owe federal, state and local income tax on your earnings. Inheritance is not income and, therefore, is not subject to income tax.

The inheritance tax is also different from the estate tax because payment of the latter comes from the deceased’s estate before any disbursements are made to the estate's beneficiaries. Inheritance taxes, on the other hand, are due upon receipt of the inheritance by individual beneficiaries and are calculated on the value of the assets bequeathed to each beneficiary.

How Do Inheritance Taxes Work?

Inheritance tax, like other types of taxes, varies by the amount inherited and the state.

Eleven states had an inheritance tax in 2001. Since then, five of those states (Connecticut, Indiana, Louisiana, New Hampshire, and Tennessee) have repealed their inheritance tax statutes. Only six states impose an inheritance tax, and one — Maryland — levies both estate and inheritance taxes. Iowa is in the process of repealing, with a full repeal by 2025. 

The applicable tax rates differ among the states that do have an inheritance tax. There are also interstate differences with respect to exemptions granted to lineal heirs and collateral heirs. Even where states might have similarities in how they exempt specific classes of beneficiaries (for instance, siblings), each state may apply different standards to whether such exemptions should also extend to the spouses of those heirs. 

The rate of inheritance tax differs from state to state and may vary based on the amount of the inheritance, the decedent's resident status (resident or nonresident) and the beneficiary’s class (spouse, sibling, religious institution, qualified charity, etc.).

Typically, lineal heirs (children, grandchildren and parents) are either exempt from the tax or have a lower tax rate than collateral heirs (cousins, aunts, uncles, nephews, nieces and unrelated individuals).

Who Has to Pay an Inheritance Tax?

While 12 states charge estate tax, which is taken directly from the deceased estate before an inheritance is passed on, only six states currently have an inheritance tax. By 2025, there will only be five states with an inheritance tax: Nebraska, Kentucky, Pennsylvania, New Jersey, and Maryland. 

Any person or organization that receives assets is responsible for paying inheritance taxes. There is no federal inheritance tax in the United States but if you live in a state that imposes inheritance tax, you'll be responsible for paying the relevant amount. Maryland is the only state that imposes both an estate and inheritance tax. 

Inheritance Tax Thresholds

Each state has different tax classes applicable to various types of beneficiaries.

States also differ in how they treat the same type of beneficiary. For instance, one state might be exempt or have a lower rate for a sibling compared to another beneficiary like a friend. Many also have a sliding scale, in which the first X amount is exempt. 

Some states may offer unlimited exemptions to some beneficiaries, and only limited exemptions for others. For example, surviving spouses are exempt from paying inheritance tax in all states. Here are a few other important facts:

• The top tax rate for lineal heirs is between 1% and 4.5%.
• The top rate for collateral heirs (cousins, nieces, nephews, etc.) ranges from 10% to 18%.

These differences impact the amount of inheritance tax paid by a beneficiary. For instance, the state of New Jersey exempts the first $25,000 of inheritance by the sibling (Class C) of a decedent, while Iowa offers no such exemptions for sibling (Class B) inheritance. An Iowa resident inheriting up to $25,000 from a sibling will pay tax amounting to $625 + 6% of amounts exceeding $12,500.

While it is the responsibility of the beneficiary to ensure that you pay your share of the inheritance tax owed, sometimes the estate of the deceased will pick up the tab. Because the inheritance tax can sometimes be substantial, some individuals and families make provisions for dealing with the tax in their wills so they don’t burden their beneficiaries. 

Here is a table summarizing the state inheritance tax thresholds and exemptions:

Inheritance Tax vs. Estate Tax

Inheritance and estate taxes are two distinct types of taxes that states may charge. With the exception of Maryland, all other states charge either estate or inheritance tax — or neither — but not both. 

While estate and inheritance taxes may appear to be semantics, they are distinctive in effect. While both are collected after someone dies, estate tax is collected before the inheritance is finalized. It, as the name implies, is deducted from the deceased's estate. An estate tax is assessed on the overall value of the estate. 

On the other hand, inheritance tax is based on an individual bequest of property. For example, an estate may have $10 million in assets, but it is distributed amongst multiple beneficiaries and an individual beneficiary may only receive $2 million. 

Who is responsible also differs. The estate is responsible for paying the estate tax, whereas the beneficiary must pay the inheritance tax. Sometimes, the estate will also pay the inheritance tax or have provisions for the inheritance taxes noted in the will. 

Twelve states and the District of Columbia collect a state estate tax and the federal government also has an estate tax. In contrast, only six states collect an inheritance tax and there is no federal inheritance tax.

How Can You Avoid Taxes on Inheritance?

There are some ways to avoid inheritance tax. The simplest? Live in a state without inheritance tax. Of course, moving isn't a solution for many. However, even then if you sell an asset you will need to pay capital gains tax. If you live in a state that imposes inheritance taxes, you can still take steps to (potentially) minimize your tax bill after an inheritance. 

Popular estate-planning vehicles include living trusts, irrevocable trusts, and grantor-retained annuity trusts. For example, you can use an irrevocable trust to avoid inheritance tax. 

If you want to ensure that your heirs avoid inheritance tax, you can transfer asset ownership through an irrevocable trust. Because those assets don't legally belong to the person who set up the trust, they aren't subject to estate or inheritance taxes when that person passes away. 

Final Tips on Inheritance Tax

Most states offer some inheritance value tax-free, which can help you save more, regardless of your tax bracket. Direct descendants are exempt in all states except Nebraska and Pennsylvania. In addition, there are vehicles you can use to pass on your wealth to heirs tax-free. In some states, such as Nebraska and New Jersey, charitable organizations are also fully exempt. 

You will also need to consider gift tax when looking at estate and inheritance tax. You can also check out free tax software, what to do if you filed your taxes wrong, or consider moving to states with no tax. Consider working with a financial advisor, financial planner, CPA, or estate planner to ensure your heirs are set up and protected for the future or for more tips on building generational wealth.

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