According to the IRS Publication 559, an inheritance or "a bequest is the act of giving or leaving property to another through the last will and testament." IRS says "any distribution of income (or property in kind) to a beneficiary is ... includible in the beneficiary's gross income to the extent of the estate's distributable net income." This quite confusing definition may explain why often times the term "inheritance tax" is not properly used. Many politicians and even tax professionals widely use terms "estate tax" and "death tax" when discussing inheritance taxes. To avoid negative implications on your personal tax situation, it's vital to understand how inheritance tax differs from estate tax.
Inheritance tax is collected from the individual who inherited money or property from a deceased person. Estate tax, on the other hand, is imposed on the fair market value of the estate, and it is due from the estate itself. The value of the estate is determined through the appraisal process, and it is common for the beneficiary to use estate holdings to settle the tax liability on the estate. While estate taxes are taxes imposed by the state on the gross appraised value of the entire estate, inheritance taxes are assessed on the actual portion of the net estate distributed to the beneficiary.
Federal Inheritance Tax
Inheritance tax rates may fluctuate depending on the number of variables. The biggest factor is the fair market value of your inheritance. This will determine how much can be excluded from tax and the tax rate to be applied to the remaining non-excludable value.
Depending on your state of residence, you may become liable for federal and state inheritance taxes. U.S. federal tax rates are progressive (from 10 percent to 35 percent). and they depend on the beneficiary's earnings. Once you have an appraised value of your inheritance, it should be fairly easy to estimate your tax rate based on the tax brackets information available on the IRS website.
State Inheritance Tax
Contrary to how federal inheritance tax is determined, state inheritance tax rates may either be the exact rates, progressive rates or they simply may not exist.
As of 2010, the following states were assessing inheritance tax: Pennsylvania, New Jersey, Nebraska, Iowa, Kentucky, Maryland and Indiana. If you happen to be a transferee (heir) of the estate, be prepared to pay a state estate tax if you live in New York, New Jersey, Maine, Maryland, Minnesota, Connecticut, Delaware, Ohio, Rhode Island, Tennessee, Vermont, Washington, Oregon and District of Columbia.
U.S. states that do collect inheritance taxes may impose different tax rates on your inheritance depending on your relationship with the decedent. In some states, if you are a surviving spouse or a close relative (child, siblings, parents), you can be fully exempt from the inheritance tax. However, if you are not related to the decedent or if you are a distant family member, be prepared to pay the highest inheritance tax rate applicable to your state.
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