Does Your State Have Estate or Inheritance Taxes?
While it’s unlikely that your estate will be subject to federal estate taxes given the $12.06 million threshold (in 2022), it may well have to pay state estate or inheritance taxes. Whereas estate taxes are based on the value of the entire estate, an inheritance tax is based on the relationship between the person inheriting and the deceased. Currently, 12 states and the District of Columbia have estate taxes and six have an inheritance tax, with Maryland having both. Rates and thresholds vary, with both subject to change by state legislatures. Here’s where things stand as of this writing:
States with Estate Taxes Threshold Rate
Connecticut $5.1 million 7.2-12%
DC $5.6 million 16%
Hawaii $5.49 million 10-15.7%
Illinois $4 million 0.8-16%
Maine $5.8 million 8-12%
Maryland $5.4 million 16%
Massachusetts $1 million 0.8-16%
Minnesota $3 million 13-16%
New York $5.8 million 16%
Oregon $1 million 10-16%
Rhode Island $1.5 million 0.8-16%
Vermont $4.2 million 16%
Washington $2.193 million 14-20%
States with Inheritance Taxes
New Jersey 0-16%
Every state has its own tax structure but, as you might guess from the fact that many have the same rates, they are similar. They relate to the tax structure in existence before Congress increased the threshold from $600,000 beginning in 2004. Up until that time, many states had a so-called “sponge tax” based on the federal estate tax then in existence. The federal tax allowed a credit for state estate taxes up to set percentages depending on the size of the estate. In other words, if the state estate tax was $100,000 and this fit within the federal credit limits, the estate could simply subtract this amount from the federal estate tax owed. For example, if the federal tax was $500,000, the estate would pay $400,000 to the IRS and $100,000 to the state tax authorities, but if the state had no estate tax, the estate would pay the same total amount, $500,000, but all to the IRS. So many states simply charged the amount of the federal estate tax credit. That way the estate paid the same amount of tax, but a portion of it went to the state instead of to the IRS, in effect “sponging up” the state estate tax credit allowed on the federal return.
But this system was upended when Congress reformed the estate tax because in addition to raising the threshold for taxation from $600,000 to $5 million over time (with the maximum then indexed to increase with inflation and subsequently doubled), it eliminated the state estate tax credit and as a result, also eliminated the estate taxes of all of the states that tied their taxes to the credit. Since the states had not decided as a policy or budget matter to eliminate their estate taxes, this came as a shock and many responded by reenacting their taxes to tie them to the federal system in place in 1999.
Massachusetts as an Example
The way this works in Massachusetts, where I practice, is that for estates in excess of $1 million, we fill out the federal estate tax form in use in 1999 (using a tax form from the last millennium gets crazier with every passing year) in order to determine the estate tax credit then in existence and the tax due today. Interestingly (at least to those who work in this field), unlike the federal estate tax which only taxes the amount over the threshold for taxation, if a Massachusetts estate exceeds the $1 million threshold, all of it is taxed, though at much lower rates than the federal estate tax.
The gift tax structure is also different. Massachusetts has no gift tax. So, you can give any amount to anyone without reporting it to the state. However, these gifts, to the extent they exceed the $15,000 federal gift tax exclusion, must be added back into the estate to determine whether it exceeds the $1 million threshold. If it does, what’s left will be taxed even if it is less than $1 million. Here’s an example of how this works:
Jon Adams has $1.2 million. He gives $100,000 to each of his three children and then dies with an estate of $900,000. In preparing his estate tax return, the children must add back in their $300,000 in gifts to determine whether he has a taxable estate. However, they need only pay taxes on the $900,000 remaining. So this saves some money in taxes, but not everything, reducing the tax from approximately $45,000 to approximately $28,000.
The Massachusetts and other state tax systems also differ from the federal system because they have not enacted portability. In traditional estate tax planning, husbands and wives shelter the amount they can give away tax free through trusts that keep these funds out of the estate of the surviving spouse. Doing this in Massachusetts and other states with the same tax structure can shelter up to $1 million from being taxed when the surviving spouse passes away. Depending on the size of the estate, the marginal tax rate – since the estate tax is graduated – and whether it eliminates estate taxes entirely, this can save the estate of the surviving spouse anywhere from $60,000 to $160,000 in taxes.
We provide this detail about the Massachusetts estate tax system as an example. Since each state that has an estate or inheritance tax has its own structure, only a local estate planning attorney can advise on state estate tax planning or probate administration.
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Is a retirement account with a named non-spouse beneficiary subject to MA estate taxes or inheritance tax? Is it treated as part of the estate or separate?
Yes, it is part of the taxable estate even though it’s not part of the decedent’s probate estate. Problems can arise in terms of allocation of the estate tax since it may be hard to get the beneficiary to pay her proportional share. This can be the case especially with retirement funds since the beneficiary may have to liquidate a portion and pay income taxes in order to come up with the money to pay the estate taxes. So, it’s something to consider in advance. The individual’s will can include an allocation clause saying how he wants the taxes to be paid.
For federal estate tax, do we need to file a return if the gross estate is over the threshold, even if charitable donations bring the taxable estate below it?
Yes. The IRS needs to be able to evaluate whether the charitable deductions actually qualify.