Understanding the Interplay of State Estate and Inheritance Taxes with Federal Estate Tax

Most folks know that the federal government imposes an estate tax on estates with total assets that exceed $12.92 million in 2023. The Internal Revenue Code (“Code”) Section 2010 calls that amount the “Applicable Exclusion Amount” (“AEA”) and adjusts it for inflation annually. Even if individuals do not have that number etched in their memory, they understand that they need not worry about estate taxes at the federal level unless their estate includes assets well into the millions. Some might even understand that the temporary doubling of the AEA sunsets on January 1, 2026, or understand that portability permits the surviving spouse to “port” or use the amount of their decedent spouse’s unused AEA. Most people require only a cursory understanding of estate taxes at the federal level to make decisions with respect to their Estate Plan. If you live in a state that imposes a state estate tax or an inheritance tax, then you need to understand estate taxes at the state level, as well.

Death taxes at the state level fall into one of two categories: estate taxes which are those imposed upon the estate itself, like those at the federal level, or inheritance taxes which are taxes imposed on the individuals inheriting the property. Twelve states plus the District of Columbia impose a state estate tax. Six states impose inheritance taxes. Maryland stands alone in imposing both and is one of only two states that allows portability. Hawaii also gives its residents the benefit of portability.

Most of the states that impose a state estate tax impose a progressive tax which means that the tax rate increases as the value of the estate increases. In 2023, two states, Connecticut and Vermont, impose a flat tax. Connecticut taxes resident decedents whose estates exceed $9.1 million a flat tax of 12% on the value that exceeds the exclusion whereas Vermont taxes resident decedents whose estates exceed $5 million a flat tax of 16% on the value exceeding its exclusion. Seven of the ten remaining states that impose a state estate tax and the District of Columbia all impose a top tax rate of 16%. Hawaii and Washington have the highest estate tax rate at 20%. Maine imposes the lowest rate of 12% for estates whose assets exceed the state exclusion amount of $6,410,000. These states vary in the amount of estate assets that they exclude from tax. Oregon comes in at the lowest, with a mere $1 million exclusion whereas Connecticut follows the federal amount and allows $12.92 million to escape taxation under state law beginning in 2023.

Some states like Illinois, Maine, Maryland, Massachusetts, Minnesota, Vermont, and Washington also recognize a state Qualified Terminable Interest Property (“QTIP”) deduction. The state QTIP deduction, like the federal QTIP deduction found in Code Section 2056, provides an estate with an unlimited marital deduction for property passing to the surviving spouse in trust if the trust meets certain requirements. But for the QTIP deduction granted in the Code, property passing in trust to the surviving spouse ordinarily would not qualify for the marital deduction. Interestingly, while neither Kentucky nor Pennsylvania has a state estate tax, both recognize a state QTIP.

Of the states that impose an inheritance tax, Kentucky and New Jersey have the highest rate of 16%. Iowa has begun to phase out its inheritance tax, with full repeal scheduled for 2025. It has a top rate of 6% in 2023. All the states that impose an inheritance tax exempt surviving spouses from the tax and others fully or partially exempt other immediate relatives. In 1926, the federal government began offering federal credit for state estate taxes. This provided a way to equalize the amount of tax paid by anyone regardless of their state of residence. Some estates paid taxes at the state level, while others paid it at the federal level, but no estates paid it at both levels, which happens now that the federal government has phased out the state estate tax credit and instead gives a deduction for state estate taxes paid. When that happened, many states, like Florida, stopped collecting state estate taxes because their state provisions were linked to the federal credit, while others, like Indiana, repealed their estate tax retroactively.

Obviously, this article only began to scratch the surface of this complex topic. Everyone worries about tax implications both for their estate and their beneficiaries. When residents understand how their state taxes estates and beneficiaries, that could drive high-net-worth individuals to states with lower estate and inheritance tax burdens. If you have questions regarding the implications for your estate and beneficiaries, reach out to me and I can help you understand the impact that state estate and inheritance taxes could have on you and your loved ones.