Inheritance Tax: Definition, State & Federal

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

Inheritance taxes are imposed on the heir when he or she receives property from a deceased person. As we'll see in this lesson, only a few states levy the inheritance tax; the estate tax is much more common.

A Game of 'Telephone'

You may be familiar with a game called 'telephone.' The rules are quite simple. A group of people sit in a circle. One person starts the game by whispering something into the ear of the neighbor sitting on his or her right side. The neighbor then whispers the same message to the person to his or her right, and so on until the message finally comes back to the person who started the 'telephone' call.

Normally, the message gets jumbled up somewhere in the relay. 'Old-fashioned oats' becomes 'gold-plated goats.' The message loses its luster. The same is true of the transfer of wealth from one generation to the next. Value is lost (i.e., taxes are paid) in the transfer or the relay.

In this lesson, we'll describe specifically how inheritance taxes can 'jumble up' the transfer of wealth from one generation to the next.

Estate Tax vs. Inheritance Tax

The transfer or receipt of property upon the death of an owner is often subject to estate and/or inheritance taxes. Huh, what does this mean? Well, if the tax is imposed on the right to pass property at death, it is an estate tax. If the tax is imposed on the right to receive property from a descendent, it is termed an inheritance tax. For example, if your grandmother has an estate worth $10 million and she transfers the whole amount to you, she might have to pay estate taxes on the transfer and you might have to pay inheritance taxes when you receive the property.

Tax Treatment of Inheritance Taxes

The Federal government only imposes an estate tax; it does not impose an inheritance tax. The states, however, differ in their treatment of inheritance taxes. Only six states levy the inheritance tax. Usually, the tax divides the descendant's heirs into classes based on their relationship to the descendent. The closer an heir is related to the descendent, the lower the tax rates imposed and the greater the exemption allowed. Also, some states completely exempt from taxation property passing to a surviving spouse.

Real-World Example: New Jersey

Let's see a real-world example, using New Jersey. The state puts descendants into these categories:

  • Class A beneficiaries are exempt from the inheritance tax. They are the deceased person's immediate family members, which include the spouse, domestic partner, parent or grandparent, child, stepchild, grandchild or lineal descendant of a child.
  • Class B beneficiaries were deleted when Jew Jersey's law changed.
  • Class C includes the deceased person's brother or sister, spouse of the deceased person's child, and the surviving spouse of the deceased person's child.
  • Class D includes everyone else.

Now for the tax consequences:

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