Estate Tax Vs Inheritance Tax Vs Death Tax - What's the Difference?

There is a lot of confusion with the so called "Death Tax".  People use the terms Estate Tax, Inheritance Tax, and Death Tax, interchangeably. Let's take a look at what these terms actually mean...

The Estate Tax was enacted in the early 20th century. It took the federal government a few years to discover that people could circumvent the tax by giving property away before they died. To prevent that, the government enacted a gift tax.

Twelve states and the District of Columbia collect an estate tax at the state level as of 2019. Indiana had an estate tax but it was repealed in 2013, and Tennessee followed suit in 2016. New Jersey and Delaware eliminated their estate taxes last year.

The federal government also imposes an estate tax, but it does not have an inheritance tax. Only six states collect inheritance taxes and one of them—Maryland—collects both an estate and an inheritance tax.

So what's the difference? 

Lets take the first two terms:

Estate vs Inheritance.  The two terms are used almost universally interchangeably in the media, but really mean two different things.  

Estate Tax

The estate tax is a tax on property (cash, real estate, stock, or other assets) transferred from deceased persons to their heirs. It is calculated based on the net value of property owned by a decedent as of the date of his/her death. The estate's liabilities are subtracted from the overall value of his/her property to arrive at the net taxable estate. 

All the jurisdictions that currently collect a state estate tax offer exemptions, and they can vary. Only the net value of an estate exceeding the amount of this exemption is taxed, and the tax comes off the top of the estate before bequests can be made to beneficiaries from anything that remains.

The federal estate tax is levied only on the portion of an estate’s value that exceeds the exemption level, minus deductions, such as for charitable giving. Largely because of the generous exemption level, fewer than 0.1 percent of estates pay any estate tax, and typically at fairly moderate rates.

As for the federal estate tax, the exemption at that level is $11.18 million as of 2018, so very few estates find themselves liable for it.

The below chart shows the 13 states and the District of Columbia which have estate taxes. Note, that most of these are below the federal exclusion amount of $11.18 million.

(Source: Nerdwallet.com)

Inheritance Tax

An inheritance tax,  meanwhile, is calculated based on who receives a deceased person's property. Heirs are liable for paying this tax, although a will sometimes provides that the estate should pick up this expense before it is divided among the beneficiaries.

Transfers to surviving spouses are completely exempt from the inheritance tax in all six states that collect it.

Four states—Iowa, Kentucky, Maryland, and New Jersey—also exempt transfers to surviving children and grandchildren, but property passing to children and grandchildren is subject to the state inheritance tax in Nebraska and Pennsylvania. More collateral heirs, such as brothers, sisters, nieces, and nephews, or friends, must typically pay this tax.

These are the states that tax an Estate, an Inheritance, or both (Maryland!) in 2019:

Some Stats!

• Only 1 out of every 700 deaths results in paying the federal estate tax today. The vast majority of estates — 99.9% — do not pay federal estate taxes.

• While the top estate tax rate is 40%, the average tax rate paid is 17%.

Death Tax

As for the Death Tax, there really is no such thing.  It's more of a political tool to disparage the Estate Tax or Inheritance Tax.  Basically, the argument goes that the income being taxed was already taxed, and amounts to double-taxation by the government.  Also, it seems fairly cruel to hit family and friends of a recently deceased with a large tax bill at a time when they are presumably still grieving. 

How can Estate and Inheritance Taxes be avoided?

Starting with estate taxes, there are ways of avoiding them, legally.  Aside from the obvious of spending it all or giving it away before you die, you can set up an irrevocable trust to shield some or all your assets from exposure to the tax. Also, since many states do not have an estate or inheritance tax, and you will presumably be retired at this point in your life, you can simply move to a state that does not have the taxes.  

Other Steps:

• Irrevocable Trust - The trust will shield assets and distribute them according to your wishes after you pass. This trust removes all of your property from your possession and control and places it in the control of a trustee. 

• Make Donations - Create Charitable Trusts; by donating to charity, you’ll lower the value of your estate and end up with an extra tax break. 

• Gift Assets - The IRS mandates a $15,000 annual exclusion per person, per donor (so a married couple can give away $30,000).  

• Spousal Gifts -  Under current IRS law, you can give unlimited gifts to your spouse. In other words, if you are nearing your death and do not wish to be encumbered with a will, you can simply give all of your property and wealth to your spouse, tax free. There are however a few catches with this rule. For instance, the gift must be given at least four years before your death. Otherwise, certain states will still include the gift in your estate.

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