One of the most important components of financial planning is ensuring a sound plan is in place for the transfer of an individual’s estate upon their passing. Several changes have been (and continue to be) made to federal and state laws that govern the transfer and subsequent taxation of estates in the United States, leaving many people feeling overwhelmed by the sheer complexities that exist. Having said that, a common point of confusion for individuals is the difference between the estate tax and inheritance tax. While these terms may seem identical, in actuality they refer to two entirely different taxes.
An estate tax is a posthumous tax that is levied on the value of property owned by a deceased person. In addition to the federal estate tax, which currently has an exemption of $5,490,000 and is indexed for inflation, fifteen states also impose their own estate tax. While three states (Delaware, Hawaii & Maine) currently match the federal estate exemption, exemptions for residents in other states can be as low as $1,000,000 (Massachusetts & Oregon). However, it is worth noting that states could elect (as they historically have) to change these exemptions, which is exactly what lawmakers in New Jersey did late last year by deciding to phase out the state’s estate tax completely by 2018. New Jersey’s prior estate tax exemption of $675,000 was notably low in comparison to that of other states, but was increased to $2,000,000 for 2017 and will be rendered useless once the estate tax is eliminated come January 1st, 2018.
While some residents of New Jersey will likely look to adjust their estate plan in response to this recent change, individuals must remember that the state still imposes an inheritance tax. Unlike the estate tax, which is primarily based on the value of one’s estate and is imposed on all transfers with the exception of certain deductions such as the marital and charitable deduction, an inheritance tax is mainly determined by who receives the deceased person’s property. In other words, an inheritance tax will only be enforced if the estate (or portion of) passes to someone who is subject to the inheritance tax under state law. At present, six states levy an inheritance tax on their residents; two of which (Maryland & New Jersey) also impose an estate tax. Spouses are exempt from this tax in all six states, while transfers to children and grandchildren are exempt from the inheritance tax in four states (Iowa, Kentucky, Maryland and New Jersey). Although Nebraska and Pennsylvania are the only two states that currently impose an inheritance tax on estate transfers to children or grandchildren, residents of all six states should be aware that transfers to other types of heirs such as brothers/sisters and nieces/nephews may be subject to an inheritance tax.
In summation, having an understanding of the differences that exist between the estate tax and inheritance tax is an essential element of estate planning and could help individuals avoid potential confusion or headaches that may exist in the future.