State Inheritance and Estate Taxes – Beware of Little Brother

Since the passing of the Tax Cuts and Jobs Act in 2017, the federal estate tax exemption was doubled and continues to adjust to inflation. The amount has grown to $13.61 million per individual. This amount is scheduled to be roughly cut in half upon the sunset of the rules in 2026. Yet the possibility of an extension persists and has become a greater possibility as the Republicans, who were the original architects of the exemption’s expansion, reclaim the federal seats of power. While fewer estates are being subjected to the IRS’s attention, a number of its littler siblings have not been so kind.

A total of 19 states levy taxes on the transfer of assets at death through two different methods: most are calculated on the total estate value of the decedent, similar to the federal process, but some have an inheritance tax instead that is calculated by looking at the various recipients of the assets. One standout is Maryland which levies taxes in both fashions.

Estate Tax States:

For the states that levy an estate tax (CT, DC, HI, IL, MA, MD, ME, MN, OR, NY, RI, VT, and WA), all but Connecticut are decoupled from the federal exemption amount, meaning their exemption amount does not match the federal amount. The exemption is considerably lower in these cases. As with the federal tax calculation, a gradually increasing tax rate is applied to the estate value once the exemption amount is surpassed, with the exception of Vermont and Connecticut that have flat tax rates.

Inheritance Tax States:

Despite the name inheritance tax, this tax is levied by the residing state of the decedent and not where their heirs or beneficiaries live (IA, KY, MD, NE, NJ, and PA). In all cases, the tax rate levied upon the inherited assets depends on the familial relationship (or lack thereof) of the beneficiary with increasing rates the further the distance in relation. In other words, inheriting as a child or parent would be less of a tax than an aunt, uncle, or cousin which would, in turn, be less than an unrelated person. The amount exempt from tax may also change based on the relationship of the beneficiary to the decedent, but in cases where there is an exemption, the amounts are relatively nominal.

A Closer Look:

Using Illinois as an example, the state imposes a tax on estates valued greater than $4,000,000. This figure is not indexed for inflation and includes lifetime gifts made above the annual exclusion amount. Also, a very important distinction from the federal exemption is a lack of portability between spouses. Put plainly, if it doesn’t get used by the decedent, then it is lost. Whereas the unused portion of federal exemption can be transferred to the surviving spouse if elected. A key area we often see this issue arise is with retirement accounts (IRAs/401(k)s) and their beneficiary elections. Additionally, how the tax itself is calculated is rather convoluted. Two separate calculations of tax are computed and the lower of the two is the determined amount. The first grants the exemption and adds back gifts made during one’s lifetime. Once the value exceeds $4,000,000, however, the tax rate is a whopping 40%. The second calculation ignores lifetime gifting and assesses a graduating tax rate between 0.8%-16% on the value of assets owned at death. While the tax rate is lower in this case, there is no exemption allowed. Given the lack of portability and a separate tax determination when incorporating gifting, a first step in looking to mitigating the tax for couples is reviewing the titling of assets between spouses.

As with other taxes it seems, states’ estate and inheritance taxes remain complex. It is important to have clarity on the potential impact these taxes may have on loved ones and to assess the possibility of mitigating them. Please contact your JMG advisor with any questions that you might have. We invite you to share this article with others who may also find it helpful.

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