One aspect of estate planning that many are often curious about is how taxes will be applied to an estate. Whether you’re an individual planning to pass your assets on to family or you’re the beneficiary of an inheritance, you may have questions about how taxes could impact your estate or inheritance.
Here, we’ll introduce you to important aspects of the estate tax and inheritance tax, such as how the taxes are applied and what differences exist between the two. In particular, we’ll look at how the estate tax and inheritance tax affect residents of Colorado.
Also, note that while we can address the basics of these taxes and how they impact your estate planning at large, it’s always a smart idea to involve an attorney in the process. State and federal law are subject to change and even subtle changes can mean big differences in the strategy you put in place for your estate. An experienced attorney will know of any changes and can help you navigate the current landscape.
What Is Estate Tax and When Does It Apply?
The estate tax is a tax applied on the transfer of a deceased person’s assets. In other words, when an estate is passed on, the federal government taxes the transfer. Note, however, that the estate tax is only applied when assets exceed a given threshold. For 2021, this amount is $11.7 million (or $23.4 million for married couples).
Estate tax can be applied at both the federal and state level. However, not many states have an estate tax. The state of Colorado, for example, does not levy its own estate tax.
What Is Inheritance Tax and When Does It Apply?
An inheritance tax is a tax paid by an individual that has inherited money or other assets from someone who has passed away. Unlike with the estate tax, which is levied on the estate, in this case the person who inherits the money pays the inheritance tax.
Generally, you do not have to report inheritance to the IRS, as it’s not considered taxable income. While the estate tax is a federal tax, an inheritance tax will only apply if your state has one in place. The state of Colorado, for example, does not levy its own inheritance tax.
An important note here, however, is that if the individual you’re receiving inheritance from resides in a state with inheritance tax then it can apply regardless of the state you live in. In other words, it’s the deceased’s state tax laws that will apply, not the heir’s state tax laws.
Understanding the Difference Between Estate and Inheritance Tax
While similar in nature, there are two main differences between the estate tax and an inheritance tax. The first distinction to note is that the estate tax is applied on a federal level. This means that regardless of which state you live in, if your estate exceeds the specified threshold, the estate tax will be applied. Note, however, that in addition to the federal estate tax, certain states apply their own estate tax. The inheritance tax, on the other hand, only applies in those states that have it. Currently, only a handful of states have an inheritance tax in place.
The second distinction to note is how these taxes are applied. With the estate tax, the tax is applied to the entire estate of the deceased individual. With an inheritance tax, on the other hand, the tax is applied to the heir’s individual share of the deceased’s estate.
As you go about your estate planning, you might find it interesting that the majority of estates don’t end up paying any form of inheritance tax or estate tax to the IRS. So, how is that the case?
Well, it’s partly that many estates do not meet the threshold in which the estate tax would apply to them. And in regards to the inheritance tax, many do not live in states that have one, as only a handful of states do.
But an important factor to this that shouldn’t be overlooked is the role that effective estate planning can play in avoiding these taxes for larger estates. An estate-planning attorney can help you implement an effective strategy to protect and pass on your assets. Regardless of the taxes discussed here, if you have a larger estate, it can be worthwhile to enlist the services of an attorney to ensure that all of your bases are covered and wishes carried out.