If you thought that the federal estate tax exemption eliminated any tax triggers for heirs, you could be in for an unpleasant surprise in some states.
In 2019 the federal estate tax exemption is $11.4 million for an individual and $22.8 million for a married couple. That means heirs to an estate valued at those amounts or less pay no federal estate tax.
If the decedent lived in one of 17 states and the District of Columbia, however, heirs could get an unpleasant surprise in the form of an estate or inheritance tax. Nebraska, Iowa, New Jersey, Kentucky, Pennsylvania have an inheritance tax. Connecticut, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington, District of Columbia have an estate tax. Maryland is the only remaining state with both an estate and an inheritance tax.
While the difference between an estate and inheritance tax may seem trivial, it’s not.
The tax rules for the jurisdictions that impose these taxes vary widely. In all cases, the exemption amounts for the state estate taxes are lower than the current generous exclusion under the federal estate tax. Of the states with estate taxes, exemption amounts range from $1 million (Massachusetts and Oregon) to $5.6 million (Hawaii and Maine) in 2018. In states with an estate tax, the top rate ranges from 12 percent in Connecticut to 20 percent in Washington. Most states have a graduated tax rate that increases with the size of the estate and tops out at 16 percent.
Inheritance tax rules work very differently from state to state. In Iowa, Kentucky, Maryland and New Jersey, the exemption amount for spouses and lineal heirs is unlimited. Nebraska and Pennsylvania also have an unlimited exemption amount for spouses but may impose a tax on other relatives, depending on the size of the estate and relationship to the decedent.
Collateral heirs and others outside of the small circle of tax-favored beneficiaries often take the hardest hit in states with an inheritance tax because they have a very low exemption or none at all. Tax rates are also high, ranging from 10 percent to 18 percent. Those low exemption amounts and high tax rates can create a huge tax bill for brothers, sisters, nieces, nephews, and others in this category who inherit even a relatively modest estate in a state with inheritance taxes.
For an example of how this works consider New Jersey, where the estate tax was recently repealed but the inheritance tax remains intact. Here, “Class C” beneficiaries, who include siblings and sons- and daughters- in law, pay no tax on amounts up to $25,000. Amounts over that are taxed at rates on a graduating scale from 11 percent to 16 percent. For “Class D” beneficiaries, which include nephews, nieces, and unrelated friends, the first $700,000 is taxed at a rate of 15 percent. Anything over that is taxed a rate of 16 percent.
For some relatives or friends, the tax tab can add up quickly. Using a recent example from the nj.com, assume an uncle who lives in the Garden State with no spouse or children leaves a $1 million bequest to two nephews. If they receive $500,000 apiece each would have a whopping $75,000 tax liability on their portion of the inheritance.
Many lawyers are in the business of figuring out ways for people to reduce federal and state estate and inheritance taxes for beneficiaries, and if you think such taxes may be an issue you may want to consult one of them. Common recommendations from professionals include gifting, trusts, or other strategies that involve giving up access to or control over money in exchange for tax benefits.
Another common piece of advice is to become a legal resident of a state that doesn’t impose an estate or inheritance tax. That’s one reason retirees from colder climates often put down roots in Florida, which is one of those states. For people who don’t like palm trees or hot weather but still want to keep a bequest from state clutches, a state closer to home might fit the bill.
Picking up stakes and moving somewhere else is certainly nothing to do lightly. After all, one’s home is one’s home. But some people, especially those whose heirs could come up against a six-figure tax bill, may decide it’s worth the trouble.
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