Understanding Estate Tax Caps: Federal & State Inheritance Limits

In discussions about death taxes, we sometimes use the terms "estate tax" and "inheritance tax" interchangeably, but they actually describe two distinct taxes. Estate tax is levied by the IRS and 14 states against a decedent's assets constituting his estate. The "cap" refers to the portion of estate assets excluded from this tax, currently $5,000,000 for federal estate tax. An inheritance tax is imposed by eight states against property received by each heir. The estate of the decedent is not taxed. Each state sets its own cap on property that will be excluded from either estate or inheritance tax.

The History of Wealth Transfer Taxation

A kind of wealth transfer tax was first imposed in 1797 as a way to pay for wars. In 1916 the first estate tax law was passed, followed by a gift tax in 1924. According to a 1994 paper published by the Tax Foundation, "With the exception of the mid -1930s, transfer taxes have never represented a significant share of federal revenue." Although these taxes apply to the wealthy, a 2009 Congressional Budget Office brief commented, "Federal transfer taxes have historically made up a relatively small share of total federal revenues -- accounting for 1 percent to 2 percent of total revenues in most of the past 60 years."

State Estate Tax

Most states use a "pick-up" tax that levies their own estate tax based on a federal estate tax credit calculation, which was the portion of the federal estate tax given to the decedent's state of residency. That federal credit payment has been slowly phasing out since 2002 and, effective January 1, 2005, is now applied as a deduction against state estate taxes. A few states such as Florida collect no additional tax from estates or heirs. Many states have modified their tax laws to collect taxes above the federal credit. For example, Connecticut imposes up to a 12 percent tax on estates over $2,000,000.

State Inheritance Tax

States charging inheritance tax usually impose a higher percentage tax on distant relatives and non-related beneficiaries while exempting or minimally taxing spouses, children and other immediate family beneficiaries. Typically, inheritance tax rates are between 7 percent and 12 percent. Property exemption thresholds can range from a low of $500 to $100,000 and higher. A few states, such as New Jersey and Maryland, levy both an inheritance tax and an estate tax but usually set higher exemption thresholds for estate tax -- $1,000,000 for Maryland and $675,000 for New Jersey.

Estate and Inheritance Tax Avoidance Strategies

Effective use of the exemption caps on state and federal transfer taxes is an important estate planning goal. For 2011 and 2012, estates valued at $5,000,000 or less pay no federal estate tax. Wills should be written to ensure full utilization of spousal exemptions to minimize or eliminate tax at the first death and again at the death of a surviving spouse. Credit Shelter Trusts accomplish this goal by placing property equal in value to the current exemption into a trust and transferring the remainder of the estate to the surviving spouse tax-free.