Inheritance Tax Pros & Cons

An inheritance tax can permanently alter the financial future of a family following a death. Also known as an estate tax or death tax, inheritance tax is a tax imposed on the personal property that a deceased individual leaves behind. Federal inheritance taxes were reduced from 2006 to 2010, but ongoing state inheritance taxes and a return of the federal inheritance tax figure into many people's financial futures.

The biggest advantage of an inheritance tax is the revenue it provides for federal and state governments. Inheritance taxes provide millions of dollars in revenue, which in turn funds government projects and pays for the salaries of government employees.

An inheritance tax also allows governments to offer income tax breaks. This takes some of the tax burden off workers without forcing the government to cut spending or reduce services.

Inheritance tax is a progressive tax. This means that it places a higher tax burden on wealthy individuals. Inheritance tax consists of a percentage of the value of inherited property. The changes in federal inheritance tax law in 2006 set the exemption limit at $1 million, meaning that any estate below this level is exempt from all inheritance taxes.

One potential drawback of an inheritance tax is its ability to discourage savings. According to a report from the U.S. Congress Joint Economic Committee, studies by economists Kenneth Chapman, Govind Hariharan and Lawrence Southwick, Jr. found that during periods of higher estate taxes, the amount of taxable assets falls, suggesting that taxpayers spend more and amass less in response to the higher tax rate.

Inheritance taxes fall under criticism for being a double tax. This is because much of the property or money inherited has already been taxed as earned income. Levying a second tax on the same property may appear unfair, especially in the case of estates that include little or no investment income.

However, in other cases, the estate tax can serve as a primary tax. According to the Center on Budget and Policy Priorities, many estates include unrealized capital gains, which would go completely untaxed if not for the estate tax.

Inheritance tax is among the most complex types of tax. The Internal Revenue Service admits as much, recommending that anyone subject to an inheritance tax consult with an attorney or certified public accountant. This can prove an added cost and slow down the inheritance process.

Inheritance taxes may encourage taxpayers to search for loopholes to reduce or eliminate their tax burden. These loopholes may include gifting property in small amounts over an extended period of time or setting up joint ownership of property and bank accounts with family members. According to the U.S. Congress Joint Economic Committee, gifted property generally moves from a parent in a higher tax bracket to a child in a lower bracket, reducing the revenue that governments earn from the same asset. For governments that count on inheritance tax for revenue, these loopholes can present a gap between expected and actual revenue, contributing to a budget deficit.