When planning your estate, understanding the taxes you and your beneficiaries may need to pay is key in determining how you allocate your assets. Two kinds of taxes occur when you pass on your assets: an inheritance tax, paid by recipients of your estate and imposed by some states; and an estate tax, which may also be imposed by your state, but is always imposed by the federal government. The key is to avoid states with inheritance tax, estate tax, or both.
While inheritance tax and estate tax are two different types of tax, both may earn the “death tax“ moniker. An inheritance tax is paid by the person receiving the inheritance. Since no federal inheritance tax exists, inheritance tax is imposed only by certain states.
Inheritance tax rates vary according to kin and marital relationships. A surviving spouse is exempt from inheritance tax. As an example, depending on state law, a relative inheriting money may not pay as much tax as a friend unrelated to the deceased person.
Inheritance and estate taxes are calculated by adding up all the assets titled in the name of the decedent and applying the applicable tax rate. Such assets may include:
For tax purposes, the fair market value of these assets on the owner’s death date is the benchmark. For estates valued above the federal exemption level – currently $11,580,000 per person or $23,160,000 for a married couple – any tax due is paid by the estate administrator to the IRS within nine months of the death date. The same generally holds true if the late person lived in a state with an estate tax. Only after all relevant estate taxes are paid can the personal representative of the estate distribute the remainder of the estate to beneficiaries.
The good news is that as of 2020, very few states impose inheritance tax. For those states, direct descendants of the deceased, such as their children and grandchildren, are usually exempt; however, those who are not related by blood or marriage will likely have to pay tax on their inheritance.
States imposing inheritance tax include Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania. Maryland is the only state with both inheritance and estate taxes. Some states exempt a certain portion of inheritance value before taxes kick in. As of 2020, the highest rates applied to the fair market value of the inheritance for these states are:
Not every state exempts lineal descendants from inheritance tax. In Nebraska and Pennsylvania, children and grandchildren must pay inheritance taxes, although at lower rates ranging from 1% to 4.5%.
Some states do not impose inheritance taxes on smaller estates. For example, Iowa only imposes inheritance tax on estates valued at more than $25,000.
Other types of exemptions are common. In Pennsylvania, certain types of agricultural land are not subject to inheritance tax if the property is transferred to those eligible for the exemption. Laws such as these keep working farms in the same family without the fear of selling them to pay the tax.
Depending on the state, some heirs will pay more than others if they are not lineal descendants. Siblings will generally pay a lower tax rate than nieces and nephews for their inheritance. In other states, these relatives are not subject to inheritance taxes.
Since there is no standard rule for which relatives must pay inheritance tax and who is exempt; it really is a matter determined on a state-by-state basis. In New Jersey, grandchildren and stepchildren do not have to pay inheritance tax, but step-grandchildren do. An attorney will explain whether you owe tax based on the state’s law, the amount inherited, and the category of your relationship to the deceased.
Only the largest estates are subject to federal estate tax. The estate tax is not an inheritance tax, as it is paid to the federal government by the estate and not by the heirs. However, the imposition of an estate tax still means heirs receive less money.
On December 22, 2017, President Donald J. Trump signed the Tax Cuts and Jobs Act (TCJA) into law. This legislation raised the federal estate tax exemption to $11,580,000 per person for 2020. For a married couple, the exemption is now $23,160,000.
The TCJA keeps the exemption at that level until 2025. Whether Congress will extend the TCJA remains to be seen. Should the exemption end that year, expect the amount to revert to its 2017 level, approximately $5.5 million per person or $11 million per couple.
Under the TCJA, fewer than 1,000 estates are subject to federal estate tax each year. Estates that must pay federal estate tax will owe 40% on the amount above the exemption. For example, if the amount above the exemption is $1 million, the IRS receives $400,000.
While a federal estate tax is imposed only on large estates, some states impose taxes on estates with a lower value than the federal exemption. Perhaps you are left an inheritance by a person living in a state without an inheritance tax. Even if that estate is worth less than the federal exemption, your inheritance amount may diminish if the estate is also subject to a state estate tax. Such taxes can take a big chunk out of what you may have thought you would receive.
Currently, 11 states and the District of Columbia impose estate taxes. New York, for example, has a $5.74 million exemption for 2020 and imposes an estate tax of 16% above the exempted amount. However, the New York tax law also stipulates that when an estate is worth more than 105% of the exemption threshold, the entire estate is subject to tax. Other exemption amounts and top estate tax percentages include:
Keep in mind, these are the highest rates for each state for the estates subject to tax. There are other caveats, and the devil is in the details. For example, most states apply graduated rates depending on the value of the estate. Hawaii applies graduated rates of 10%, 11%, 12%, 13%, 14%, 15.7%, and 20% depending on the value of the estate.
Some states adjust their exemption amounts annually for inflation, while others do not. Oregon is one example. Because its exemption amount has not been adjusted for inflation for years, even the estates of relatively middle-class individuals who own a home and have retirement assets are hit hard by estate taxes.
In some states imposing estate taxes, married couples may combine their exemption amounts. This is known as portability, but not every state permits it. For more questions regarding estate tax, contact your local financial advisor.
Perhaps you live in a state with no inheritance tax, but your parents reside in a state that does. You may want to discuss ways to avoid inheritance taxes with them, or with any other person from whom you expect to receive an inheritance. Exhibit A below showcases states that have the inheritance tax, estate tax, or both.
Maybe your parents are willing to relocate to a state without an inheritance or estate tax. If moving is out of the question, they may want to consider alternatives and plan their estates with the goal of wealth preservation and potential avoidance of future state estate or inheritance taxes. For these purposes, consult an estate planning professional. This is not something that even a reasonably sophisticated investor should try on their own.
The planning professional may recommend the establishment of an irrevocable life insurance trust for tax purposes. An irrevocable trust is one for which the grantor, or person establishing the trust, cannot change the terms.
As far as the IRS is concerned, once the grantor establishes the trust, that trust is now separate from their estate. Once the irrevocable trust is created, the grantor applies for a life insurance policy. It is the trust, not the grantor, named as the policy’s owner.
While the grantor is not permitted to manage this trust, they are allowed to appoint a trustee for that purpose. In most cases, it is wise to appoint an attorney or financial professional to act as a trustee rather than a family member.
If you live in a state with an inheritance tax, sound estate planning can minimize some of its effects. For example, if you are healthy and expect to live more than two years, planned giving to individuals who are otherwise subject to the inheritance tax can reduce your taxable estate. That can mean avoiding inheritance taxes.
These measures require careful planning. In 2020, you cannot give away more than $15,000 per individual to reduce the size of your estate. If you want to give more than that, you must file a gift tax return. You can, however, give $15,000 to as many people as you like, and your spouse can give away the same amount without tax consequences.
While generally only high net-worth households have to worry about federal inheritance and estate taxes, state tax is a different story. Depending on the state, even a relatively modest inheritance can trigger a sizable tax. In some states, even close relatives will end up with a large tax burden after inheriting.
State inheritance and estate taxes are big considerations when making retirement plans. Perhaps moving to a more tax-friendly state is not an option due to family and community ties. After all, it is out of love and care for your family that you make estate-planning decisions. You want to leave your loved ones as comfortably provided for as possible. Consult an estate planning professional to develop a customized strategy and start minimizing your tax obligations.
Every family situation is different, and so is every estate plan. While your financial advisor can explain the intricacies of state inheritance tax law, you can discuss the concerns you have about family members’ needs and with that information, a well-crafted estate plan is designed. Your advisor will inform you what each heir might owe given the current tax situation and your estate’s value. From there, you can devise ways to ensure your heirs receive their inheritance with every possible tax advantage.