What are Inheritance Taxes?

An inheritance tax is a state tax that you pay when you receive money or property from the estate of a deceased person. Unlike the federal estate tax, the beneficiary of the property is responsible for paying the tax, not the estate. However, as of 2011, only eight states impose an inheritance tax. And even if you live in one of those states, many beneficiaries are exempt from paying it.

The key difference between estate and inheritance taxes lies in who is responsible for paying it.  An estate tax is levied on the total value of a deceased person's money and property and is paid out of the decedent’s assets before any distribution to beneficiaries.

However, before an estate tax is due, the value of the assets must exceed certain thresholds that change each year, but generally it’s at least $1 million. Because of this threshold, only about 2 percent of taxpayers will ever encounter this tax.

Once the executor of the estate has divided up the assets and distributed them to the beneficiaries, the inheritance tax comes into play. The tax amount is calculated separately for each individual beneficiary, and the beneficiary must pay the tax. For example, a state may charge a 5 percent tax on all inheritances larger than $2 million. Therefore, if your friend leaves you $5 million in his will, you only pay tax on $3 million, which is $150,000. The state would require you to report this information on an inheritance tax form.

The federal government does not have an inheritance tax. The eight states that impose an inheritance tax include Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. Of course, state laws are subject to change, so if you are receiving an inheritance, check with your state's tax agency. The tax rates on inheritances can be as low as 1 percent or as high as 20 percent of the value of property and cash you inherit.

Depending on your relationship to the decedent, you may receive an exemption or reduction in the amount of inheritance tax you must pay. For example, most states exempt a spouse from the tax when they inherit the property from a husband or wife.

Children and other dependents may qualify for the same exemption, though in some cases, only a portion of the inherited property may qualify. Generally, the higher rates of tax will be paid by those who inherit property from a decedent with whom they have no familial relationship.