How To Avoid Estate And Inheritance Taxes

Let’s talk estate and inheritance taxes.  First we’ll do definitions, and Investopedia is great for those. 

What is an estate tax?

An estate tax is a levy on estates whose value exceeds an exclusion limit set by law. Only the amount that exceeds that minimum threshold is subject to tax. Assessed by the federal government and a number of state governments, these levies are calculated based on the estate’s fair market value (FMV) rather than what the deceased originally paid for its assets. The tax is levied by the state in which the deceased person was living at the time of their death. 

It seems (to me at least) a bit cruel to have to pay a tax for your estate simply because you die, but this is indeed the case in certain circumstances. 

What is an inheritance tax?

An inheritance tax is a tax imposed by some states on the recipients of inherited assets. In contrast to an estate tax, an inheritance tax is paid by the recipient of a bequest rather than the estate of the deceased. 

Notice they didn’t mention any federal component here, inheritance taxes only exist in some states.  An easy way to think of this is if your parent dies and leaves you money, an inheritance tax could tax that money in some circumstances.

Both of these may leave a sour taste in your mouth, so let’s get to the meat of the matter and see who might be at risk to pay these taxes.

Who Pays

I like maps and I cannot lie, you other mappers can’t deny.  Even though it would be pretty easy to list the states that have estate and inheritance taxes as there aren’t too many, a map is better and more fun.  So the folks at Tax Foundation have us covered. (click for a larger version)

As you can see twelve states and the District of Columbia currently have an estate tax.  The Tax Foundation article explains that most states have been moving away from estate taxes after the federal government phased out the state estate tax credit it first implemented in 1926. 

States that do still have an estate tax have been generally raising the exemption amount, with the exception of the District of Columbia.  Washington D.C. recently lowered it’s exemption amount from $5.8 million to $4 million. 

There are quite a few members of the FIRE community I know that would have to pay an estate tax on their assets if they had the misfortune of dying while being a resident of Washington D.C.

Inheritance Tax

As you can see on the map there are currently only six states that have an inheritance tax.  And Maryland holds the distinction of being the only state with both an estate tax and an inheritance tax. 

As someone who was born and raised in Baltimore and lived in Maryland until I was about 30, I can confirm that Maryland is a very high tax state all around.  In the D.C. region many of us jokingly call it the “People’s Republic of Maryland”.  When I left Maryland I had a lot more money in my pocket, everything seems to be taxed high there. 

Nebraska has the highest rate of the six states with an inheritance tax that tops out at a whopping $18%.  That doesn’t mean everything is taxed at 18% for anyone who inherits it, it’s complicated of course.  Because that’s what bureaucrats do. 

The Platte Institute explains Nebraska’s inheritance tax:

In short, if a resident of Nebraska dies and their property goes to their spouse, no inheritance tax is due. If it goes to their parents, grandparents, siblings, children, or a lineal decedent (or their spouse) then the tax is applied to anything over $40,000 at a rate of 1%.  If it goes to an aunt, uncle, niece, nephew, or any lineal decedent of these people (or their spouse) then the tax applies to any property over $15,000 at a rate of 13%. For anyone else, the tax is applied to all property of more than $10,000 at a rate of 18%. 

Ouch.  $10,000 isn’t a huge sum of money in the grand scheme of things.

Run Away

So how do you avoid estate and inheritance taxes?  Don’t live (or die) in a state that has them!  Ha, now you’re angry over my click-baity title, but darn if it ain’t true.  Of course avoiding the federal estate tax is harder. 

The federal estate tax doesn’t kick in until someone dies with $12.06 million in assets or more.  So most folks don’t have to worry about it, but devotees of the FIRE movement shoot for the stars, so we’re a bit different. 

NerdWallet does a great breakdown of the federal estate tax rules and nuances, it’s worth a read. 

If you do expect to die with more than $12 million, your options to avoid this tax are limited.  Besides spending or giving away your money, an irrevocable trust is one method to legally avoid paying this tax. 

That’s it financial warriors, now you know how to avoid paying estate and inheritance taxes. 

Your Turn – I’ll throw a fun question out this time: Do you expect to die with more than $12 million in assets?