How Inheritance Taxes Work: Estate Tax, Inheritance Tax, and Planning

Estate Tax vs. Inheritance Tax: Key Differences

The terms "estate tax" and "inheritance tax" are often used interchangeably but refer to legally distinct taxes. Understanding the difference is important for estate planning purposes.

An estate tax is levied on the total value of a deceased person's estate before assets are distributed to beneficiaries. It is paid by the estate itself, not by the recipients. The federal government imposes an estate tax, and several states also have their own estate taxes.

An inheritance tax is levied on the beneficiaries who receive assets from an estate. It is paid by the heirs based on what they receive, not by the estate. Inheritance taxes are imposed only at the state level in the United States—there is no federal inheritance tax. As of 2024, six states impose inheritance taxes: Iowa (being phased out), Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Federal Estate Tax

The federal estate tax is imposed under the Internal Revenue Code and applies to the taxable estate of U.S. citizens and residents. The key features are:

• Exemption threshold: For 2024, the federal estate tax exemption is $13.61 million per individual ($27.22 million for married couples using portability). Estates below this threshold owe no federal estate tax.
• Tax rate: The federal estate tax rate is 40% on the taxable estate value above the exemption.
• Sunset provision: Under the Tax Cuts and Jobs Act of 2017, the doubled exemption is scheduled to revert to approximately $7 million (inflation-adjusted) after December 31, 2025, unless Congress acts to extend it.
• Marital deduction: Assets transferred to a surviving U.S. citizen spouse pass free of estate tax, regardless of amount, under the unlimited marital deduction.
• Charitable deduction: Amounts left to qualifying charities are deducted from the taxable estate.

State Estate Taxes

Twelve states and the District of Columbia impose their own estate taxes as of 2024: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. State exemption thresholds are often lower than the federal threshold, meaning some estates that owe no federal tax still owe state estate tax.

Massachusetts has the lowest exemption—estates above $2 million are subject to state estate tax at rates ranging from 0.8% to 16%. Oregon's top rate is 16% on taxable estates above $1 million. Washington State's estate tax reaches 20% on the highest bracket.

State Inheritance Taxes

The Step-Up in Basis Rule

One of the most significant tax benefits for inherited assets is the stepped-up cost basis rule under IRC Section 1014. When an heir inherits appreciated assets—such as stocks, real estate, or a business—the cost basis of those assets is "stepped up" to their fair market value on the date of the decedent's death.

For example, if a parent purchased stock for $10,000 that grew to $100,000 by the time of death, the heir inherits the stock with a $100,000 cost basis. If the heir immediately sells the stock, no capital gains tax is owed on the $90,000 appreciation. This effectively eliminates the capital gains tax on assets held until death, making the step-up in basis one of the most valuable provisions in the U.S. tax code for estate planning.

The Gift Tax and Annual Exclusion

The federal gift tax is closely linked to the estate tax and prevents individuals from avoiding estate tax by giving away assets before death. Gifts above the annual exclusion amount are counted against the lifetime gift and estate tax exemption.

For 2024, the annual gift tax exclusion is $18,000 per recipient. An individual can give up to $18,000 to any number of people without filing a gift tax return or using any lifetime exemption. A married couple can combine their exclusions for $36,000 per recipient per year (gift-splitting).

Gifts directly to educational institutions for tuition (not room and board) and to medical providers for healthcare expenses are fully exempt from gift tax without limit, regardless of the annual exclusion.

Planning Strategies to Minimize Estate and Inheritance Taxes

• Annual gifting: Systematically gifting up to $18,000 per recipient annually reduces the taxable estate over time. Over 20 years, a couple giving to two children could transfer $1.44 million free of gift and estate tax.
• Irrevocable life insurance trusts (ILITs): Life insurance proceeds placed in an ILIT are excluded from the taxable estate, providing a tax-free inheritance to beneficiaries.
• Charitable remainder trusts (CRTs): Transferring appreciated assets to a CRT provides income during the grantor's lifetime, a charitable deduction, and removal of assets from the estate.
• Grantor retained annuity trusts (GRATs): A GRAT allows appreciation above a specified "hurdle rate" to pass to heirs free of gift tax.
• 529 plan superfunding: Contributions of up to $90,000 per beneficiary ($18,000 × 5 years) can be front-loaded into a 529 plan in a single year under special gift tax rules.

Comparison of Federal Tax Implications by Transfer Method

Estate and inheritance tax planning is a complex area that intersects federal and state tax law, trust law, and beneficiary designations. Given the scheduled 2026 sunset of the doubled federal exemption, high-net-worth individuals should review estate plans with qualified advisors before the end of 2025.

This article is for informational purposes only and does not constitute financial advice. Consult a qualified financial advisor before making investment decisions.