Estate Taxes vs. Inheritance Taxes

Chris Maurer |

Preparing for the future requires more than just creating a will. It also involves careful estate planning to ensure the ones you love receive assets after your death. Your estate and the gifts bequeathed to family and friends will be subject to federal and state taxation at this time, and it’s important to work with an experienced financial advisor who understands these issues and can help minimize taxation. Learn more about the difference between estate taxes and inheritance taxes and how planning ahead can help preserve your legacy and provide for loved ones. 

What Is An Estate?

While it's often thought of as land and housing, an estate consists of a collection of assets in its entirety. From your home to your living room furniture, everything of value that you own is considered part of your estate. An estate could include the following: 

  • Investment and retirement accounts, such as 401(k)s, IRAs, and 403 (b)s
  • Financial securities, including U.S. bonds, and bank accounts
  • Real estate holdings
  • Art collections
  • Antique items
  • Vehicles
  • Life insurance policies
  • Business interests

When you pass away, your estate will be given to your beneficiaries. The purpose of an estate plan is to protect your assets and outline how your estate is distributed between heirs. Without careful planning, a large portion of your legacy could be taken by the government in the form of estate and inheritance taxes.

What Is Estate Tax?

An estate tax is a levy placed on an estate and paid for by the estate itself. Estates are subject to federal tax, and in some cases, state tax. While all states have imposed an estate tax at some point in history, only a handful still practice this today. When it comes to taxation, only estates valued over a minimum threshold are subject to this tax. More often than not, the sting of the state tax is felt over that of the federal tax. This is because the threshold for federal taxes is typically much higher than a state’s.

How Are Estate Taxes Calculated?

Estate taxes are calculated based on the total net value of the assets. Net worth is the gross value of the estate minus any outstanding debts or liabilities. These liabilities can include: 

  • Credit card debt
  • Mortgages
  • Auto loans
  • Funeral expenses
  • Estate settling costs

The estate tax is paid before any assets are distributed to beneficiaries. The executor (an appointee who delivers the deceased's last will and testament) is the person responsible for filing this tax. It's worth noting that the assessment of your estate is calculated based on fair market value rather than what was originally paid. 

What Is Inheritance Tax?

Similar to an estate tax, an inheritance tax is a levy on inherited assets. While the federal government does not have an inheritance tax, a handful of states across the country do. The payment for this tax is the responsibility of the beneficiary. If your estate is being divided between multiple beneficiaries, each person is responsible for his or her own inheritance tax. This tax rate depends on inheritance value, the state of residence, and the beneficiary's relationship to the deceased and breaks down as follows: 

  • Transfers to surviving spouses are exempt in all applicable states
  • Transfers to surviving children and grandchildren are exempt in select states
  • Distant heirs (siblings, nieces, nephews, friends) are subject to this tax  

One of the pitfalls of this tax is the possibility of getting hit twice. If your beneficiary inherits an estate large enough to qualify for federal estate tax and lives in a state with inheritance tax, a sizable portion of your property hasn't actually gone to your loved ones.  

How to Avoid Estate and Inheritance Taxes

There are a few ways to minimize the impact of estate and inheritance taxes. Some strategies a financial advisor may suggest include:

  • Taking out a life insurance policy: The death benefit of a life insurance policy does not qualify for inheritance taxes. Therefore, you could buy one in the amount you want to bequeath and make your preferred heir the beneficiary.
  • Placing assets into a trust: Trusts are similar to wills. They let you pass assets to preferred beneficiaries while avoiding state probate requirements and expenses.
  • Gradually giving money away: You don't have to wait until after death to give your loved ones money. You may give it away at any time during your life in amounts that won't qualify for gift taxes so long as they don’t exceed stated thresholds.
  • Donate to meaningful causes: Charitable donations ensure most of your assets go toward a worthy cause. Deductions for charitable donations could help offset the taxes on your inheritance as well. 

Begin Your Estate Plan with Park Place Financial

Finding ways to protect your legacy and granting your loved ones peace of mind after your passing starts with consulting with a professional. At Park Place Financial, our advisors can help you navigate the estate planning process with your family's best interests in mind. For more information about inheritance and estate taxes, contact us today.