08 Jun What’s the Difference Between an Estate Tax and an Inheritance Tax?

Although Arizona doesn’t have an estate tax, the federal government does. Arizona doesn’t impose an inheritance tax either, but you could still have to pay taxes on inheritance that comes from another state. At Phelps LaClair, we understand that estate and inheritance tax laws and the differences between them can be confusing. 

Having to pay estate or inheritance taxes in Arizona is rare, but it can still happen. We put together this guide to help you understand estate vs. inheritance taxes so there’s no confusion when you or a loved one passes away. 

The Difference Between an Estate Tax and an Inheritance Tax

What Is an Estate Tax?

An estate tax is imposed by the federal government (and sometimes by the state) on the value of the deceased person’s estate. The tax is taken from the fair market value of the estate at the time of death, not what they had originally paid for the assets during their lifetime. 

The states that impose estate taxes include:

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

Luckily for residents of the Grand Canyon State, there is no estate tax in Arizona. Plus, most estates are too small to be subject to the federal estate tax. Only estates valued at over $11.7 million during the 2021 tax year or over $12.06 million for the 2022 tax year are subject to the federal estate tax. 

What Is an Inheritance Tax?

The main difference between estate and inheritance taxes is that the estate tax applies to the decedent’s assets, while the inheritance tax applies to the amount the decedent leaves to their beneficiaries. However, while not all states have an inheritance tax, the ones that do have different thresholds for how much of the inheritance has to be before it becomes taxable.

Only the following six states have inheritance taxes:

• Iowa
• Kentucky
• Maryland
• Nebraska
• New Jersey
• Pennsylvania

Who Pays These Taxes?

Another major difference between estate and inheritance taxes is who pays them. The decedent is responsible for paying an estate tax, so the executor will use their estate’s assets to pay the taxes. Inheritance taxes, on the other hand, are paid by the beneficiary. 

Which Assets Are Subject to the Estate Tax?

All assets in an estate are subject to the estate tax, but only if they exceed the threshold for federal and/or state estate taxes. The calculation for estate taxes does not include any debts or other deductions such as charitable donations taken from the estate at the time of death.

For example, if your estate is worth $3 million when you pass, and $1 million is deducted for charitable donations, the estate would then be worth $2 million when estate taxes are calculated. 

The estate would not be subject to the federal estate tax in this case, because it does not exceed the threshold. However, if you lived in Massachusetts when you passed, that state has an estate tax threshold of $1 million, so your estate would still be subject to the state estate tax there. 

When Is an Inheritance Subject to the Inheritance Tax?

If you’ve received an inheritance, or if you are planning to leave one, it’s important to know whether the inheritance is taxable. Inheritance taxes are calculated based on the state the deceased person lived in. 

This means that if you live in Arizona and leave an inheritance to someone else in Arizona, that inheritance will not be taxable. If you live in Arizona and leave an inheritance to someone who lives in or moves to another state, that inheritance will not be taxable either.

However, if you live in Arizona and receive an inheritance from someone in one of the six states with inheritance taxes, that inheritance is taxable. 

The states with inheritance taxes do have certain exemptions, however. For instance, your surviving spouse would be exempt from the inheritance tax in any of the six states. Descendants are also exempt from the inheritance tax in all states except Nebraska and Pennsylvania. 

Each state also has its own threshold for how much of the inheritance is taxable, like with the estate tax. Only the amount that exceeds the threshold is taxable. 

How to Avoid Estate and Inheritance Taxes

As long as you live in a state like Arizona that does not have estate or inheritance taxes, and keep your estate below the exemption thresholds, your estate and the inheritances you leave will not be taxable. However, if you’re still worried about estate and inheritance taxes, there are steps you can take to ensure you avoid them. 

How to avoid estate and inheritance taxes:

• Set up a trust to leave your assets to beneficiaries
• Reduce your estate through gifting (the 2022 gift tax exclusion is $16,000 per person)
• Disclaim the inheritance someone leaves to you
• Own a life insurance policy, which is tax-free when left to a beneficiary

Estate Planning Lawyer in Mesa and Chandler, Arizona

Proper planning can help you minimize estate and inheritance taxes or avoid them altogether. The expert estate planning lawyers at Phelps LaClair will work with you to design a plan that protects your estate and minimizes taxes. We’ve been serving the residents of Mesa, Chandler, and the surrounding areas for over 40 years. Give us a call at 480-892-2488 today to schedule a consultation. 

Images used under creative commons license – commercial use (6/8/2022). Photo by Kelly Sikkema on Unsplash