Inheritance Tax vs. Estate Tax: What Heirs Must Pay

Receiving an inheritance often comes with mixed emotions. You are grieving a loss while simultaneously navigating complex financial decisions. One of the biggest concerns for beneficiaries is the fear of a surprise tax bill. While the terms “inheritance tax” and “estate tax” are often used interchangeably, they are two completely different types of taxation. Understanding the difference determines who pays the bill, how much is owed, and whether the money comes out of the estate’s total value or your own pocket.

The Core Difference: Who Pays the Bill?

The most important distinction between these two taxes lies in who is responsible for writing the check to the government.

  • Estate Tax: This is a tax on the right to transfer property at death. The tax is calculated based on the total value of the deceased person’s assets. The estate pays this tax before any money or assets are distributed to the heirs. If you are a beneficiary, you receive what is left after the estate settles this bill.
  • Inheritance Tax: This is a tax on the right to receive property. The beneficiary is responsible for paying this tax. The rate usually depends on your relationship to the deceased and the state laws where the deceased lived.

Federal Estate Taxes: The 1% Problem

When people hear stories about the government taking 40% of an inheritance, they are usually thinking of the federal estate tax. However, the reality is that very few Americans will ever deal with this.

The federal government levies an estate tax, but it only applies to the very wealthy. As of 2024, the federal estate tax exemption is $13.61 million for an individual. This means if the total value of the estate is less than $13.61 million, no federal estate tax is due. For married couples, this exemption is portable, meaning a couple can protect up to $27.22 million from federal taxes.

For 2025, these limits are projected to rise to $13.99 million per individual.

If an estate exceeds these thresholds, the tax rate is steep. It starts at 18% and quickly climbs to 40% on the amount that exceeds the exemption limit. However, since less than 0.1% of Americans leave behind estates of this size, the federal “death tax” is rarely an issue for the average family.

State Estate Taxes: The Lower Thresholds

While the federal government might not tax your inheritance, your state might. Several states levy their own estate taxes, and their exemption limits are often much lower than the federal threshold. This catches many families off guard.

If the deceased lived or owned property in one of these states, the estate might owe taxes even if it is well below the $13 million federal cap.

As of 2024, twelve states and the District of Columbia collect their own estate taxes:

  • Connecticut
  • Hawaii
  • Illinois
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • New York
  • Oregon
  • Rhode Island
  • Vermont
  • Washington
  • District of Columbia

Oregon has the lowest threshold in the nation at just $1 million. If a relative passes away in Oregon with a house worth $700,000 and retirement accounts worth $400,000, the estate is over the limit and taxes must be filed. Massachusetts is another state with a lower threshold, kicking in at $2 million.

New York has a “cliff” tax structure. If the estate value exceeds the exemption (currently around $6.94 million) by more than 5%, the exemption is eliminated entirely, and the estate is taxed on the entire value, not just the overage.

Inheritance Taxes: The "Location" Tax

Inheritance tax is much less common, but it directly impacts the beneficiary. This tax is not levied by the federal government at all. It is strictly a state issue.

Currently, only six states impose an inheritance tax:

  • Iowa (Note: Iowa is in the process of phasing this out. For deaths occurring on or after January 1, 2025, the tax is repealed.)
  • Kentucky
  • Maryland
  • Nebraska
  • New Jersey
  • Pennsylvania

How Rates Are Determined

In these states, the tax rate depends on your relationship to the deceased. States generally categorize heirs into classes:

  1. Class A (Exempt): Spouses are universally exempt from inheritance taxes in all six states. In many states, children and grandchildren are also exempt or taxed at a very low rate.
  2. Class B/C (Collateral Heirs): This includes siblings, nieces, nephews, and aunts/uncles. They often face tax rates ranging from 4% to 16%.
  3. Class D (Non-relatives): Friends or unrelated partners usually face the highest rates.

For example, in Pennsylvania, the tax rates are very specific:

  • 0% for spouses and parents (if the deceased was under 21).
  • 4.5% for children and lineal heirs (grandchildren).
  • 12% for siblings.
  • 15% for other heirs (like a friend or neighbor).

If you inherit $100,000 from a friend in Pennsylvania, you would personally owe the state $15,000 in taxes.

Maryland: The Double Taxation State

Maryland is unique because it is the only state in the country that imposes both an estate tax and an inheritance tax.

If a Maryland resident passes away with an estate worth more than $5 million, the estate pays the estate tax. Then, when the remaining assets are distributed, the beneficiaries might also have to pay the inheritance tax depending on their relationship to the deceased. However, the state allows a deduction to prevent the same dollar from being taxed fully twice, but the paperwork is complex.

Reducing the Tax Burden

If you anticipate receiving an inheritance or are planning your own estate, there are strategic moves to reduce these liabilities.

The Annual Gift Exclusion

The simplest way to reduce an estate’s value is to give the money away while you are alive. For 2024, the IRS allows you to give $18,000 to as many individuals as you want without triggering a gift tax return. For 2025, this limit increases to $19,000.

If a couple has three children, they can jointly gift $36,000 to each child annually. Over ten years, this removes over $1 million from their taxable estate tax-free.

Trusts

Irrevocable trusts can remove assets from your taxable estate. Once you move assets into an irrevocable trust, you no longer own them in the eyes of the IRS. This lowers your total estate value, potentially bringing it under the federal or state exemption limits.

Moving to a Tax-Friendly State

Since inheritance and state estate taxes are location-dependent, domicile matters. This is why many retirees move to states like Florida, Texas, or Arizona. These states have no state income tax, no estate tax, and no inheritance tax. Establishing legal residency in one of these states before death can save heirs significantly.

Frequently Asked Questions

Do I have to pay income tax on an inheritance? Generally, no. You do not pay federal income tax on cash or property you inherit. However, if you inherit a retirement account like a Traditional IRA or 401(k), you will pay income tax on the withdrawals because that money was never taxed originally.

What is the “Step-Up in Basis”? This is a major tax benefit. If you inherit an asset like a house or stocks, the value of that asset is “stepped up” to its fair market value on the date of the owner’s death. If your grandmother bought a house for $20,000 in 1980 and it was worth $500,000 when she died, your cost basis is $500,000. If you sell it immediately for $500,000, you pay zero capital gains tax.

Does a will avoid estate taxes? No. A will instructs the court on how to distribute assets, but it does not shield assets from the IRS or state tax authorities. A trust is usually required for tax mitigation strategies.

Who is responsible for filing the return? The executor or administrator of the estate is responsible for filing the estate tax return and paying the bill from the estate’s funds. For inheritance taxes, the executor often files the paperwork, but the beneficiary is liable for the payment. In many cases, the executor will deduct the inheritance tax from the distribution before sending the check to the heir to ensure it gets paid.