Many people often interchange the terms estate tax and inheritance tax and confuse the differences between the two. While both are taxes associated with a person’s death and fall under the category of “death taxes”, they are two separate and distinct types of taxes. The umbrella term “death tax” can include federal estate tax, state-specific estate taxes and in six states, an inheritance tax.
Each situation is different and there are many nuances to every type of death tax, including where one lives, the size of their estate, tax laws at the time of death and the relationship of intended beneficiaries. If you wish to share your wealth upon your death with loved ones or important beneficiaries in a tax efficient way, it’s important to plan ahead to help minimize the burden and negative impact of death taxes on beneficiaries.
What is Federal Estate Tax?
Federal estate tax applies to worldwide assets owned by a US person that has passed away and, in most cases, are paid by the decedent’s estate, not the beneficiary. The current federal exemption for federal gift and estate tax in 2023 is $12,920,000 per person. The estate would not be subject to federal estate tax if the value is under that amount. Assuming there are no changes in the law beforehand, this exemption is due to sunset on January 1, 2026, and reduce to approximately $6,000,000 per person.
Notwithstanding the federal exemption, a decedent can leave an unlimited amount to his or her spouse since there is an unlimited marital deduction for federal and state estate tax purposes. However, when the surviving spouse subsequently passes away, the value of the gifted and inherited assets, if not otherwise transferred during the spouse’s lifetime, will be includable in the spouse’s estate and may be subject to an estate tax at that time. Passing assets to anyone other than the spouse (or qualified charities), including lineal decedents, could result in an estate tax if the value of assets exceeds the federal exemption at the time of death. With the Current Federal Exemption, a person can transfer substantial amounts of wealth tax free either during that person’s lifetime or upon their death.
What is State-Specific Estate Tax?
Some states impose state estate tax, which is separate from federal estate tax. It’s important to note that state estate tax is tied to the state in which the decedent resides at their point of death, not the beneficiary. Similar to federal estate tax, state estate taxes are imposed on the assets of the decedent. The tax rate is typically a range and varies from state to state. For example, in New York, the estate tax rate ranges from 3.06% to 16%. Hawaii and the State of Washington have the highest estate tax top rates at 20%.
The following 12 states currently impose a state estate tax:
- District of Columbia
- New York
- Rhode Island
- Washington State
What is an Inheritance Tax?
Separate from federal or state-specific estate taxes, inheritance tax applies when a decedent who is bequeathing assets resides in one of the 6 states that currently has an inheritance tax. This tax is the beneficiary’s responsibility. The states that currently impose an inheritance tax are:
- Iowa (inheritance tax is being phased out and will be completely eliminated for deaths occurring after January 1, 2025)
- New Jersey
In most of the states that impose an inheritance tax, spouses, lineal descendants and charitable organizations can inherit assets without being subject to an inheritance tax. For others receiving inheritances, the beneficiary must pay the inheritance tax only on the amount they received. Each state has a small exemption on amounts that are not subject to inheritance tax. However, the amounts received over those exemptions are subject to tax at a gradual rate.
What is Gift Tax?
Any transfer from a donor to an individual either directly or indirectly where money is not received in return is considered a gift. Gifts to your spouse, gifts to a political organization and tuition and medical expenses that are paid for someone else are not considered gifts. The 2023 annual gift tax exclusion amount is $17,000 per person, per donee, or $34,000 for married couples that split gifts. The donor can begin gifting this amount each year to his or her intended heirs, providing them funding to cover the inheritance tax the recipient may have to pay in the future, especially if that recipient will receive an illiquid bequest such as a house or a valuable piece of art.
New York Proposed Inheritance & Gift Tax
While New York does not currently impose an inheritance or gift tax, the NYS Senate has proposed new legislation that would create taxes for both inheritance and gifts received as well as amend the current state estate tax laws to generate more revenue for the state. While the bill has been introduced, it has not yet passed the NYS Senate or Assembly.
In order to minimize the burden to your beneficiaries, it’s important to plan ahead, consider gifts throughout your lifetime and structure documents to ensure that assets are passed to your loved ones in the most tax efficient ways. If you are living in one of the six states with an inheritance tax and wish to bequeath your assets to your beneficiaries, be sure to seek the advice of a professional with experience in trusts and estates. To avoid having your assets subject to a federal estate or inheritance tax, you can make outright gifts to loved ones now or establish lifetime trusts. The donor should look into lifetime planning to utilize the high federal estate tax exemption while it’s available to limit the death taxes ultimately paid.
In addition, you can protect beneficiaries receiving illiquid assets by requiring your estate, under your testamentary documents, to pay the taxes. You could also give that same beneficiary a specific cash bequest which would provide him or her the wherewithal to pay the inheritance tax attributable to the illiquid assets.
For an overview of key exemptions and credits for 2023, as well as planning considerations, read our recent article. If you have questions or would like to discuss the best options for you, contact your Janover professional or a member of the Janover team today.