What Are the Differences Between Estate Tax and Inheritance Tax? (w/Examples) + FAQs

An estate tax is a tax on a deceased person’s total assets, paid by the estate itself. An inheritance tax is a tax on the specific assets a person receives, paid by the heir. The core conflict for many families stems from the Internal Revenue Code § 2001, which establishes the federal estate tax. This rule creates a direct threat to preserving generational wealth, as it allows the government to claim up to 40% of a family’s assets above a specific threshold, potentially forcing the sale of a family business or home to pay the tax bill.

This tax structure affects a small but significant portion of the population. Fewer than 0.2% of estates in the U.S. are currently large enough to owe any federal estate tax. This is due to a very high exemption amount, but that amount is scheduled to be cut nearly in half at the end of 2025, dramatically increasing the number of families who will be impacted.

Here is what you will learn by reading this guide:

❓ You will understand the critical difference between who pays an estate tax versus an inheritance tax.
💰 You will learn how to calculate your potential federal estate tax liability step-by-step.
🗺️ You will discover which specific states have their own “death taxes” and how their rules can impact your family, even if you don’t owe federal tax.
🛡️ You will explore powerful legal strategies, like trusts and gifting, to legally shield your assets and maximize what you pass on to your loved ones.
❌ You will identify the most common and costly estate planning mistakes and learn exactly how to avoid them.

Part I: Deconstructing the Two Types of “Death Taxes”

To protect your assets, you must first understand the battlefield. The U.S. tax system uses two different weapons to tax the transfer of wealth after death. Though often confused, they operate in fundamentally different ways, targeting different people and different pots of money.

The Estate Tax: A Tax on the Giver’s Estate

The federal government and a handful of states use an estate tax. Think of this as an “exit tax” on the deceased person’s right to transfer their property. The tax is calculated on the total net value of everything the person owned at death, which is called their Gross Estate.

The estate itself, as a legal entity, is responsible for paying this tax. The executor of the will, or a court-appointed administrator, files a tax return (IRS Form 706) and pays the IRS directly from the estate’s funds. This happens before any money or property is distributed to the heirs.

The direct consequence is that the beneficiaries receive a smaller inheritance. While the heirs don’t write the check to the IRS themselves, the tax payment reduces the total pool of assets available to be divided among them. Economically, the heirs bear the full burden of the tax.

The Inheritance Tax: A Tax on the Receiver’s Inheritance

An inheritance tax is a completely different system used only by a few states. This tax is not based on the total value of the deceased’s estate. Instead, it is a tax levied directly on the person receiving the assets.

Each heir is responsible for paying tax only on the value of the property they personally inherit. The amount of tax owed depends on two key factors: the value of the inheritance and, most importantly, the heir’s relationship to the person who died.

This system is rooted in social policy. States with an inheritance tax use it to encourage people to leave their wealth to immediate family members. As you will see, the tax rates are lowest for spouses and children and highest for distant relatives or friends.

At-a-Glance: The Core Differences That Matter

Understanding the distinction between these two tax systems is the first step in effective estate planning. The fundamental difference always comes down to one simple question: Who writes the check?

Part II: The Federal Estate Tax Machine: How It Works

The federal estate tax is the largest and most significant death tax in the United States. It is governed by complex rules within the Internal Revenue Code, but its operation can be broken down into a clear, step-by-step process. Only by understanding this process can you begin to plan for it.

Step 1: Calculating Your Gross Estate

The process begins by taking a complete inventory of everything you own or have a legal interest in at the moment of your death. This total is your Gross Estate. A critical rule is that all assets are valued at their Fair Market Value (FMV) on the date of death, not what you originally paid for them.

The IRS casts a very wide net. The Gross Estate includes more than just your bank accounts and home.

It includes assets such as:

Cash, stocks, bonds, and mutual funds
Real estate, including your primary home and any investment properties
Retirement accounts like 401(k)s and IRAs
Life insurance policies that you own, even if the payout goes to someone else
Business interests, including family businesses and partnerships
Cars, jewelry, art, and other valuable personal property
Assets held in a revocable living trust

Step 2: Subtracting Deductions to Find Your Taxable Estate

After calculating the Gross Estate, the law allows for several important deductions. These are subtracted from the total value of your assets to arrive at your final Taxable Estate. This is the number that the IRS actually taxes.

The most common and powerful deductions include:

Debts and Mortgages: Any outstanding mortgages on your real estate and other personal debts (like credit card balances or loans) are subtracted.
Administrative Expenses: The costs of settling your estate are deductible. This includes things like attorney fees, executor fees, court costs, and appraisal fees.
Charitable Deduction: Any amount you leave to a qualified charity is 100% deductible. There is no limit to this deduction.
Unlimited Marital Deduction: This is one of the most significant deductions. Any assets you leave to a surviving spouse who is a U.S. citizen are completely exempt from the estate tax. This rule allows couples to delay paying any estate tax until the second spouse dies.

Step 3: Applying the Lifetime Exemption and Tax Rate

The final step is where the tax bill is determined. The government allows every individual a very large lifetime exemption. This is the amount of assets you can give away during your life or at death without ever having to pay federal estate or gift tax.

For 2025, the federal lifetime exemption is $13.99 million per person. A married couple can combine their exemptions, allowing them to shield nearly $28 million from taxation. Your Taxable Estate is only taxed to the extent that it exceeds this exemption amount. The tax rate on that excess amount is a flat 40%.

The 2026 Tax Cliff: Why Planning Is Urgent

The current $13.99 million exemption is not permanent. It was created by the Tax Cuts and Jobs Act of 2017 (TCJA) and includes a “sunset” provision. On January 1, 2026, if Congress does not pass a new law, the exemption will automatically be cut roughly in half, to a projected $7.5 million.

This legislative cliff creates a massive sense of urgency for families with estates valued between $7 million and $28 million. An estate that is completely tax-free today could face a tax bill of millions of dollars if death occurs after 2025. This makes proactive planning, especially strategies that use the current high exemption, a critical priority.

Scenario 1: Calculating the Federal Estate Tax

Let’s walk through a real-world example. Imagine Sarah, an unmarried individual, dies in 2025. She has not made any large taxable gifts during her lifetime.

Calculation Step	Value/Action
1. Determine Gross Estate	Sarah’s assets include a home ($3M), investments ($11M), life insurance she owned ($1.5M), and personal property ($500k). Her *Gross Estate is $16,000,000*.
2. Subtract Deductions	She has a mortgage ($500k), estate settlement costs ($250k), and left a bequest to a charity ($250k). Her *Total Deductions are $1,000,000*.
3. Find the Taxable Estate	Gross Estate ($16M) – Deductions ($1M) = *$15,000,000 Taxable Estate*.
4. Apply the Exemption	Taxable Estate ($15M) – 2025 Exemption ($13.99M) = *$1,010,000 Subject to Tax*.
5. Calculate the Tax	The amount over the exemption is taxed at 40%. $1,010,000 x 40% = *$404,000 Federal Estate Tax Due*.

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Part III: The Patchwork of State Death Taxes

While the federal estate tax affects only the wealthiest families, state-level taxes can impact a much broader group of people. A minority of states have decided to impose their own death taxes, and their rules are often very different from the federal system. It is critical to know the laws of the state where you live.

States With Their Own Estate Tax

Twelve states and the District of Columbia have their own estate tax. The most important feature of these state taxes is that their exemption amounts are much, much lower than the federal exemption. For example, Oregon’s exemption is only $1 million, and Massachusetts’ is $2 million.

This creates a common trap where an estate is far too small to owe any federal tax but still faces a significant state tax bill. For residents of these states, planning is not just for the ultra-rich.

State	2025 Estate Tax Exemption
Connecticut	$13,990,000
District of Columbia	$4,873,200
Hawaii	$5,490,000
Illinois	$4,000,000
Maine	$7,000,000
Maryland	$5,000,000
Massachusetts	$2,000,000
Minnesota	$3,000,000
New York	$7,160,000
Oregon	$1,000,000
Rhode Island	$1,802,431
Vermont	$5,000,000
Washington	$2,193,000

States With an Inheritance Tax: Where Your Relationship Matters

Five states use a true inheritance tax system: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. In these states, the tax bill is determined almost entirely by the family relationship between the deceased and the heir.

These states group heirs into “classes.”

Class A heirs, such as surviving spouses and sometimes children, are almost always completely exempt from the tax. They pay a 0% rate.
More distant relatives, like siblings, nieces, and nephews, fall into other classes and pay tax at low to moderate rates.
Unrelated heirs, like friends or unmarried partners, pay the highest tax rates, which can be as much as 16%.

Maryland is unique because it is the only state in the country that imposes both an estate tax and an inheritance tax. This means a large estate could first pay the state estate tax, and then the remaining assets could be taxed again when they are distributed to non-exempt heirs.

Scenario 2: Calculating Pennsylvania’s Inheritance Tax

Let’s see how this works in practice. Imagine Maria, a Pennsylvania resident, dies and leaves her $1,000,000 estate to four different people. Pennsylvania’s law sets different tax rates for each relationship.

Heir’s Relationship	Inheritance Amount & Tax Rate
Surviving Spouse	Receives $500,000. The tax rate for a spouse is 0%. The tax owed is $0.
Daughter	Receives $250,000. The rate for a direct descendant is *4.5%. The tax owed is $11,250*.
Brother	Receives $150,000. The rate for a sibling is *12%. The tax owed is $18,000*.
Best Friend	Receives $100,000. The rate for an unrelated heir is *15%. The tax owed is $15,000*.

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In this scenario, each heir is legally responsible for paying their own tax bill. The total tax paid from Maria’s estate is $44,250, even though her estate is far below the federal exemption.

Part IV: Powerful Strategies to Protect Your Wealth

Understanding the rules is only half the battle. The other half is using that knowledge to implement legal strategies that minimize taxes and ensure your assets go to the people you choose. Proactive planning is the key to victory.

Strategy 1: The Power of Lifetime Gifting

One of the simplest and most effective ways to reduce your future estate tax bill is to give assets away during your lifetime. The tax code provides several powerful tools to help you do this without triggering a gift tax.

The Annual Gift Tax Exclusion is your primary tool. In 2025, federal law allows you to give up to $19,000 to as many individuals as you want, every single year, completely tax-free. A married couple can combine their exclusions and give up to $38,000 per recipient.

This strategy does not use up any of your $13.99 million lifetime exemption. A consistent annual gifting program can move a significant amount of wealth out of your taxable estate over time, along with all of its future growth.

There is also an unlimited exclusion for payments you make directly to an educational institution for someone’s tuition or to a medical provider for their healthcare costs. These payments do not count against your annual exclusion or your lifetime exemption, making them an incredibly efficient way to transfer wealth.

Scenario 3: Using Annual Gifting to Reduce Your Estate

Consider a married couple, Tom and Jane, who have a taxable estate of $16 million. They have two children and four grandchildren. They decide to use the annual gift exclusion to reduce their estate below the 2025 federal exemption of $13.99 million.

Gifting Action	Estate Reduction
Year 1 Gifting	Tom and Jane each give $19,000 to their 2 children and 4 grandchildren (6 people). Total gift: ($19,000 x 2 givers x 6 recipients) = *$228,000*.
Estate Value After Year 1	$16,000,000 – $228,000 = *$15,772,000*.
Gifting Over 10 Years	If they continue this for 10 years, they will have removed *$2,280,000* from their estate, tax-free.
Final Estate Value	$16,000,000 – $2,280,000 = *$13,720,000*.
Result	Through a simple, consistent gifting plan, Tom and Jane have successfully moved their estate below the federal exemption threshold, potentially saving their heirs hundreds of thousands in estate tax.

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Strategy 2: Using Irrevocable Trusts to Shield Assets

For more complex situations, trusts are essential tools. An irrevocable trust is a legal arrangement where you permanently transfer assets out of your name and into the control of a trustee. Once the assets are in the trust, they are generally no longer part of your taxable estate.

An Irrevocable Life Insurance Trust (ILIT) is one of the most common and powerful types of trusts. Life insurance proceeds are included in your estate if you own the policy when you die. An ILIT is designed to be the owner and beneficiary of your life insurance policy.

You make cash gifts to the trust, and the trustee uses that money to pay the policy premiums. When you die, the death benefit is paid to the trust, not your estate. Because you did not own the policy, the entire payout is excluded from your taxable estate and passes to your heirs tax-free. This is an excellent strategy to provide cash to your family to pay any estate taxes without forcing them to sell assets like a home or business.

Pros of an ILIT	Cons of an ILIT
Tax-Free Payout: The life insurance death benefit is not included in your taxable estate, saving a potential 40% in federal tax.	Irrevocable: You cannot change or cancel the trust once it is created. You give up control over the policy.
Provides Liquidity: Gives your heirs immediate cash to pay estate taxes, debts, and other expenses.	Administrative Costs: There are legal fees to set up the trust and ongoing duties for the trustee.
Creditor Protection: Assets inside the trust are generally protected from the creditors of both you and your beneficiaries.	Three-Year Lookback: If you transfer an existing policy into an ILIT, you must live for three years for it to be excluded from your estate.
Control Over Distribution: The trust document dictates exactly how and when the proceeds are distributed to your heirs.	Requires Gifting: You must make annual gifts to the trust to cover the premium payments.
Leverages Gifting: You can use your annual gift tax exclusion to fund the trust’s premium payments.	Complexity: An ILIT is a complex legal instrument that requires professional drafting and administration.

Strategy 3: Advanced Trusts for Married Couples

Married couples, especially those in blended families, can use other specialized trusts to achieve their goals. A Qualified Terminable Interest Property (QTIP) Trust is a powerful tool for providing for a surviving spouse while ensuring assets ultimately go to your chosen heirs.

Here is how it works: When the first spouse dies, assets are placed into the QTIP trust. This transfer qualifies for the unlimited marital deduction, so no estate tax is paid at that time. The surviving spouse receives all the income from the trust for the rest of their life.

However, the surviving spouse cannot change the trust’s final beneficiaries. When the surviving spouse dies, the remaining trust assets pass to the heirs named by the first spouse who died. This is ideal for ensuring your children from a prior marriage will inherit your assets, while still providing for your current spouse.

Part V: The Most Common and Costly Mistakes to Avoid

Even the best intentions can be destroyed by simple mistakes. These common errors can lead to unintended tax bills, family conflicts, and your assets going to the wrong people. Avoiding them is just as important as implementing advanced strategies.

Mistake #1: Having No Plan at All

The single biggest mistake is failing to create any estate plan. If you die without a will (known as dying “intestate”), state law will decide who gets your property. This public court process, called probate, can be slow and expensive, and the state’s distribution plan may be completely different from what you would have wanted.

Mistake #2: Outdated Documents and Beneficiary Forms

An estate plan is not a “set it and forget it” document. You must review your will, trust, and powers of attorney every few years, and always after a major life event like a marriage, divorce, birth, or death. An old will could leave assets to an ex-spouse or exclude a child born after it was signed.

Even more dangerous is failing to update beneficiary designations. Assets like 401(k)s, IRAs, and life insurance pass directly to the person named on the beneficiary form. Crucially, these forms override your will. If your will leaves everything to your child, but your ex-spouse is still listed as the beneficiary on your life insurance, your ex-spouse gets the money.

Mistake #3: Ignoring Liquidity Needs

A large estate tax bill can create a crisis if the estate is made up of illiquid assets like a family business or real estate. The IRS wants cash, and they want it within nine months of death. If your estate doesn’t have enough cash on hand, your executor may be forced to sell those core assets, often at a fire-sale price, just to pay the tax bill. This is why planning for liquidity, often with an ILIT, is so important.

Part VI: The Step-by-Step Guide to the Federal Estate Tax Return (IRS Form 706)

The United States Estate (and Generation-Skipping Transfer) Tax Return, or Form 706, is the official document used to report and pay the federal estate tax. It is a long and complex form that requires a detailed accounting of the decedent’s financial life. The executor is responsible for filing it within nine months of the date of death.

Here is a breakdown of the most important sections:

Part 1: Decedent and Executor Information. This section collects basic information about the deceased person and the person legally responsible for managing the estate. The executor must attach certified legal documents, like a court order, proving their authority.
Part 2: Tax Computation. This is the main worksheet where the tax is calculated. It walks the executor through the steps of adding up the estate, subtracting deductions, applying the exemption, and arriving at the final tax due or refund.
Part 5: Recapitulation. This section is a summary of the detailed schedules. The totals from each schedule are entered here to calculate the Gross Estate and the Total Allowable Deductions.
Schedules A through I: The Asset Schedules. These are the heart of the return. Each schedule is used to list a different type of asset.
- Schedule A – Real Estate: Lists all real property owned by the decedent.
- Schedule B – Stocks and Bonds: Details all publicly traded securities.
- Schedule C – Mortgages, Notes, and Cash: Includes bank accounts and any money owed to the decedent.
- Schedule D – Insurance on the Decedent’s Life: Lists all life insurance policies owned by the decedent.
- Schedule F – Other Miscellaneous Property: This is a catch-all for everything else, like business interests, vehicles, art, and personal effects.
Schedules J through O: The Deduction Schedules. These schedules are used to justify the deductions claimed in Part 5.
- Schedule J – Funeral and Administration Expenses: Details the costs of the funeral and settling the estate.
- Schedule K – Debts of the Decedent: Lists all outstanding debts, like mortgages and credit card balances.
- Schedule M – Bequests to Surviving Spouse (Marital Deduction): This is where assets passing to a surviving spouse are listed to claim the unlimited marital deduction.
- Schedule O – Charitable, Public, and Similar Gifts and Bequests: Lists all bequests to qualified charities.

Part VII: Global Perspectives and Rules for Non-Citizens

The U.S. tax system has unique rules for non-citizens and stands out when compared to other developed nations. Understanding these differences provides valuable context and reveals critical planning issues for international families.

How the U.S. Taxes Non-Citizens

The rules for non-U.S. citizens depend on their legal “domicile,” not their citizenship. A non-citizen who is legally domiciled (a resident) in the U.S. is treated the same as a U.S. citizen for estate tax purposes. They get the full benefit of the $13.99 million lifetime exemption.

The rules are drastically different for non-resident aliens (non-citizens who are not domiciled in the U.S.). They are only taxed on their assets located within the U.S., like American real estate or stock in U.S. companies. However, their estate tax exemption is a tiny $60,000. Any U.S. assets above this small amount are subject to the full 40% estate tax. This is a major trap for foreign investors.

How the U.S. System Compares Globally

When viewed on the world stage, the U.S. estate tax is an outlier. Its top tax rate of 40% is one of the highest among developed nations, surpassed only by Japan, South Korea, and France.

However, because of its massive exemption, the tax applies to very few people. This is the opposite of the global trend. Many countries, including progressive nations like Sweden and Norway, have completely repealed their estate and inheritance taxes in recent years. They concluded that these taxes were inefficient ways to raise money and had high costs associated with compliance and administration.

Country	Top Tax Rate on Transfers to Children
Japan	55%
South Korea	50%
France	45%
United States	40%
United Kingdom	40%
Germany	30%
Canada, Australia, Sweden, Norway	0%

Frequently Asked Questions (FAQs)

Q1: What is the main difference between an estate tax and an inheritance tax? Yes. The main difference is who pays. An estate tax is paid by the deceased’s estate before assets are distributed. An inheritance tax is paid by the person who receives the assets after distribution.

Q2: Will I have to pay taxes on the money my parents leave me? No. It is highly unlikely at the federal level because of the large exemption. You would only owe state tax if your parents lived in one of the few states with an inheritance tax.

Q3: What is the federal estate tax exemption for 2025? Yes. The federal estate and gift tax exemption for an individual who dies in 2025 is $13,990,000. This is the amount that can be transferred without being subject to the federal tax.

Q4: Which states have an inheritance tax? Yes. As of 2025, five states have an inheritance tax: Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Iowa repealed its tax effective January 1, 2025.

Q5: Can I avoid estate taxes by giving my assets away before I die? Yes. You can use strategies like the annual gift tax exclusion ($19,000 per person per year in 2025) to reduce your taxable estate without gift tax consequences. Larger gifts will use your lifetime exemption.

Q6: Does my life insurance policy count as part of my taxable estate? Yes. The proceeds of a life insurance policy are included in your taxable estate if you are the owner of the policy when you die. This can be avoided by having the policy owned by an ILIT.

Q7: My uncle, who lived in Nebraska, left me $100,000. Do I owe tax? Yes. In Nebraska, a niece or nephew can inherit up to $40,000 tax-free. You would owe an 11% tax on the remaining $60,000, which would be a tax bill of $6,600.

Q8: What happens to the estate tax exemption in 2026? Yes. The current high federal exemption is scheduled to expire at the end of 2025. Unless Congress acts, the exemption will be cut to its pre-2018 level, projected to be about $7.5 million.