The dreaded New Jersey inheritance tax: How it works, who pays and how to avoid it (2024)

New Jerseyans love to hate the state's inheritance tax. (pixabay.com)

By Karin Price Mueller

New Jersey finally eliminated its estate tax, but so far, the state is hanging on to the inheritance tax.

That’s because it brings lots of revenue to the state’s coffers.

For fiscal year 2017, the most recent data available, New Jersey collected $354.58 million from the inheritance tax, according to the Division of Taxation.

The state received 6,059 inheritance tax returns that year, of which 4,446 were taxable, the division said. On average, that’s a cost of $79,752 per taxee.

We’re going to explain exactly how the tax works, who is subject to the tax and what strategies you can use to avoid it.

Let's get started.

What is the inheritance tax?

The inheritance tax is a levy that’s imposed on some inheritances, but not all. Whether you’re subject to the tax depends on your relationship to the decedent - the person who died. (More on that in a moment.)

New Jersey is one of only six states that have an inheritance tax. Nebraska, Iowa, Kentucky, Maryland and Pennsylvania are the others.

According tothe Tax Foundation, Nebraska has the highest inheritance tax rate at 18 percent. Maryland is the lowest at 10 percent.

New Jersey’s rates are between 11 and 16 percent, depending on the amount that’s being inherited and who the beneficiary is. (More on that, too, in a moment.)

The Tax Foundation keeps track of which states have estate and inheritance taxes. (The Tax Foundation)

How it started

When the tax started, it wasn’t as costly or as complicated as it is today.

In 1892, the state’s first inheritance tax was imposed. It was a mere 5 percent, and it didn’t matter who the beneficiary was. They were all treated equally.

Even spouses and children were in a taxable class.

That changed in the 1980s when spouses and children of the deceased became exempt.

That other death tax

The inheritance tax was a different tax fromthe estate tax, which was established federally in 1916.

New Jersey started its estate tax in 1934, and believe it or not, the new tax didn’t add anything to dying residents’ tax bills.

It instead made sure New Jersey got its piece of what residents were already paying to the feds.

That’s because of a provision of the federal estate tax that allowed estates to get what was called a “pick up credit” for taxes paid to their own states, said Scott Drenkard of The Tax Foundation.

So in practice, an estate would first pay the New Jersey tax, and then the credit would offset what was owed for the federal estate tax, Drenkard said.

“If your state didn’t have an estate tax it was leaving money on the table,” he said.

But when the pick up credit was repealed with the Bush tax cuts in 2001, all of a sudden, New Jerseyans would pay more estate tax: first to the state, and then to the feds, with no allowances or credits for what was already paid to the state.

Now, of course, New Jersey’s estate tax has been repealed. But the inheritance tax remains.

A look at the inheritance tax return. (N.J. Division of Taxation)

The inheritance tax today

Today, New Jersey’s inheritance tax is much more complicated than when it was first conceived with one tax rate covering all types of beneficiaries.

It starts simple.

Amounts under $500 are free of tax. After that, it gets complicated.

As we said, the state separates beneficiaries into different"classes" depending on the relationship between the beneficiary and the decedent. These classes determine if, and how much, inheritance tax will be due.

Class A

The first is Class A, and beneficiaries in this class are exempt from the tax.

Class A includes spouses, civil union partners (after Feb. 19, 2007), domestic partners (after July 10, 2004) children, legally adopted children, mutually-acknowledged children, grandchildren and great-grandchildren. It also includes parents, grandparents, and step-children, but not step-grandchildren.

Class C

Class C is when the inheritance tax starts being imposed.

Class C beneficiaries are siblings, sons- and daughters-in-law, and civil union partners or surviving civil union partners of a child of a decedent (after Feb. 19, 2007).

There’s no tax on the first $25,000.

Then, 11 percent is charged on the next 1.075 million, 13 percent on the next $300,000, and 14 percent on the $300,000 after that. Then, the rate is 16 percent for anything over $1.7 million.

Class D

Class D includes everyone else, including nieces, nephews and friends.

The first $700,000 is subject to a 15 percent tax and everything over that amount is taxed at a 16 percent rate.

Class E

Class E, like Class A, escapes the tax completely.

This class Includes qualified charities, religious institutions, educational and medical institutions, non-profit benevolent or scientific institutions, The State of New Jersey and any of its political subdivisions.

(Note that we didn’t forget Class B. That was repealed in 1963.)

How much inheritance tax will be owed will depend on the size of your estate and who will be the beneficiaries. (pixabay.com)

Examples of how the tax works

Because there are so many classes, and there are graduated rates depending on the size of the inheritance, we wanted to give you some examples of how the tax is calculated.

Let’s say someone dies with $1 million in assets, no spouse, no children. Let’s also say that person wants two nephews to share the estate.

Because nephews are Class D beneficiaries, the first $700,000 is taxed at 15 percent, said Shirley Whitenack, an estate planning attorney with Schenck, Price, Smith & King in Florham Park.

If the nephews receive $500,000 each, they’d each have a $75,000 tax bill on the inheritance.

“If the decedent structured his or her estate plan so that a portion of those assets include assets that are exempt from inheritance tax, such as life insurance, the inheritance tax will be reduced,” she said.

We’ll discuss more on that kind of planning in a moment.

If you have siblings

Let’s say another person has $1 million, no spouse, no children. They want the estate to go equally to three siblings and a niece.

The siblings are Class C beneficiaries. They each receive $25,000 that is exempt from the inheritance tax with the balance taxed at 11 percent, said Catherine Romania, an estate planning attorney with Witman Stadtmauer in Florham Park.

Each sibling would owe $24,750.

The niece is a Class D beneficiary. Her share is taxed at 15 percent, or $37,500, Romania said.

Friends and charity

This time, let’s say someone has $1 million, no spouse, and wants half to go to a friend and half to a charity.

Certain kinds of charities are exempt from the inheritance tax, said Yale Hauptman, an estate planning attorney with Hauptman and Hauptman in Livingston. He noted the burden is on the charity to prove it qualifies for the exemption.

The friend won’t be so lucky.

“The friend’s $500,000 would be taxed at 15 percent, which amounts to $75,000,” Hauptman said. “There are certain allowable deductions, however, that could reduce the taxable estate before calculating the inheritance tax.”

Planning for step-families

Not all step-relatives are created equal under inheritance tax rules.

While a step-child is considered a Class A beneficiary, as is a grandchild, a step-grandchild is not.

Let’s say someone has $1 million, no spouse, and wants to split the estate among two step-children and two step-grandchildren.

The bequests to the step-children will be tax free, said Gary Botwinick, an estate planning attorney and chair of the taxation/trusts and estates department at Einhorn Harris in Denville. But, he said, bequests to the step-grandchildren will be taxed at a 15 percent rate.

“Perhaps it would make more sense to leave the entire amounts to the step-children and request that they make a gift to the step-grandchildren,” he said. “Moreover, in the right set of circ*mstances with the correct set of facts, it might make more sense to consider an adoption of the step-children - if possible - which would make the step-grandchildren, in effect, plain ol’ grandchildren.”

Domestic partners

Consider another example.

This time, the person has $1 million and wants half to go to a domestic partner. The remaining 50 percent would be split equally between the domestic partner’s two children - children who were never adopted by the decedent.

Exactly what happens would depend on whether the estate or the beneficiaries pay the inheritance tax, said Steven Holt, an attorney and chair of the taxation, trusts and estates department at Mandelbaum Salsburg in Roseland.

There are several possibilities.

If the will says the tax would be paid by the beneficiary, the domestic partner would receive $500,000 and each child would receive $212,500 after the 15 percent inheritance tax was paid, Holt said.

The most typical scenario, Holt said, would be if the will provides that the tax is payable by the residuary estate based on percentages after the tax was paid.

“After applying the formula, the result is that the domestic partner receives $465,117, and each child receives $232,558,” he said. “The tax is $69,767, which is 15 percent of what the children have received.”

Avoiding the inheritance tax may be possible, depending on your situation. (pixabay.com)

How to avoid the inheritance tax

Avoiding the inheritance tax isn’t an easy thing, but there are strategies to minimize it and even escape it completely.

But it won’t happen automatically. You’ll need to take active measures with a variety of estate planning techniques.

For starters, certain assets are exempt in calculating the inheritance tax.

"The easiest way to leave money to a non-Class A beneficiary and escape New Jersey transfer inheritance tax is to leave the beneficiary an asset that is not subject to the tax," Romania said.

Life insurance

Life insurance is a popular estate planning tool.

That’s because life insurance owned by the deceased person and payable to a non-Class A beneficiary is exempt from the inheritance tax.

But that same life insurance payable to the deceased person's estate is not exempt.

Another option is creating an irrevocable life insurance trust for the benefit of non-Class A beneficiaries.

“Life insurance owned by an irrevocable life insurance trust, where the trust is the beneficiary of the policy and all or any of the beneficiaries of the trust are non-exempt, does work to avoid the inheritance tax,” Holt said.

More exempt assets

Proceeds of certain New Jersey pensions are exempt from inheritance tax. These include the Teachers Pension and Annuity Fund, Public Employees' Retirement System and the Police and Firemen's Retirement System, Whitenack said.

Also exempt from inheritance tax are Federal Civil Service Retirement benefits and annuities payable by the U.S. government pursuant to the Retired Serviceman's Family Protection Plan or the Survivor Benefit Plan as long as they are not payable to the estate, Whitenack said.

Also remember that if you have Class C beneficiaries, there is no tax on the first $25,000 received.

“Therefore, another strategy is to leave assets to Class C beneficiaries that are under $25,000,” Whitenack said.

IRA/401(k) strategies

401(k) plans and IRAs, which make up a large part of many taxpayers’ assets, are fair game for the inheritance tax if your beneficiaries are Class C or D.

“The tax is imposed on the gross value of the account even if the beneficiary will never actually receive the entire amount due to the imposition of income taxes,” Botwinick said. “That means that the tax is actually imposed on the share of the account that will actually go to paying income taxes – that’s really a bad deal.”

One way to reduce the sting of these taxes is to think about a Roth conversion, Botwinick said. If the the owner of an IRA converts a traditional IRA to a Roth IRA before death, and then leaves the Roth IRA to a non-Class A beneficiary, inheritance taxes will be saved on the portion of the IRA that would otherwise go to paying income taxes, he said.

Using a trust

Putting assets into a trust could be a protection against the inheritance tax, but the trust must be established while you are alive.

“The trust must be irrevocable and generally provide you with no access to income or principal from the trust,” Hauptman said. “Assets transferred within three years of death are still subject to inheritance tax unless it can be shown the transfer was not done in contemplation of death.”

This can be a tough hurdle to get over, he said, so in most cases the trust needs to be funded more than three years before death.

Gifting may help you avoid the inheritance tax. (pixabay.com)

Gifting strategies

Another way to avoid the inheritance tax is to gift assets while you’re still alive.

This, though, isn’t without potential trouble.

Lifetime gifts made within three years of death are presumed to have been made in contemplation of death and are added back to the estate for inheritance tax purposes, Whitenack said. However, assets gifted outside of that three year period are exempt.

“It may be possible to rebut the presumption that gifts made within three years were made in contemplation of death if the person established a regular gifting program to beneficiaries who are not included in the will,” she said. “This is because one of the factors that is considered is a past history of substantial gifts.”

Get out of dodge

The one way to be sure that your beneficiaries won’t owe the inheritance tax is to move to a state that doesn’t impose the tax, such as Florida.

Even if your beneficiary lives in New Jersey, your estate will be safe.

Your estate will only be taxed based on your domicile state, not the state where your beneficiary lives.

The executor of an estate is responsible for filing the inheritance tax form. (pixabay.com)

Who actually pays?

The executor or administrator of the estate is responsible for filing the inheritance tax return form and making sure that the inheritance tax is paid, even though certain assets, such as IRAs or 401(k)s, may pass directly to a beneficiary rather than through the estate, Whitenack said.

“The will can state that all inheritance taxes are to be paid from the deceased person's residuary estate, which is the balance of the estate remaining after the payment of all debts and specific bequests,” she said. “Alternatively, the will could state that all inheritance taxes are to be paid by the recipient.”

If the will is silent as to who pays the taxes or there is no will, then the inheritance taxes must be paid from recipients' shares, Whitenack said.

For example, if decedent made a bequest to a friend in the sum of $20,000, the inheritance tax would be $3,000 so the friend would only receive $17,000, Romania said.

“However, if the decedent’s will directs that the tax is to be paid from the estate, then the tax is computed by the executor and paid from the residuary estate and the beneficiary then will receive any specific bequest in its entirety without any tax being deducted,” Romania said.

In that case, the full $20,000 would go to the friend because the tax is paid with other estate funds.

What if you don't pay?

Whitenack said problems may arise if the residuary estate does not have sufficient assets to pay the tax or when the beneficiary refuses to pay his share of the tax.

“In those cases, the executor or administrator is still obligated to pay the tax and this may reduce the inheritances of other beneficiaries or amounts paid to creditors,” Whitenack said. “The executor or administrator can file suit against the beneficiary who refuses to pay the tax to recoup those funds.”

If there are no assets in the estate to pay the inheritance tax, the state can file a delinquency claim directly against the beneficiary who refuses to pay the tax, she said.

Will we see a repeal?

The estate planning attorneys we spoke to say they don’t expect the inheritance tax will be repealed like the estate tax was.

Whitenack said the elimination of the estate tax was significant, and the inheritance tax bringsmuch needed revenue to the state.

“Moreover, Governor Murphy openly opposed the elimination of the estate tax when he was campaigning for governor,” Whitenack said. “It is unlikely that he would support legislation to repeal the inheritance tax.”

New Jersey Gov Phil Murphy speaks during a press conference about the budget impasse on June 28, 2018 in Trenton. (Chris Pedota/The Record via AP)

Botwinick agreed, saying that repealing both the estate and inheritance tax would have doubled the cost of lost revenue.

“Repealing the estate tax allowed politicians to say, ‘Look how great we are. We eliminated the estate tax,’ and they are correct,” he said. “The thing is, most people aren’t even aware that New Jersey also had an inheritance tax, and by the time they figure it out, they won’t be voting anymore – if you catch my drift.”

Hauptman said there wouldn’t be much support in Trenton to get rid of the inheritance tax.

“I would think there would be a greater chance that the New Jersey estate tax could come back in the future, although I certainly wouldn’t want to be in the prediction business, given today’s political climate,” he said.

Related stories

Is $1 million enough to retire? You're asking the wrong question.

What you need to do to maximize your Social Security benefits

If you're not planning on living forever, here's what to put in your 'When I'm dead' file

Have you been Bamboozled? Reach Karin Price Mueller at Bamboozled@NJAdvanceMedia.com. Follow her on Twitter @KPMueller. Find Bamboozled on Facebook. Mueller is also the founder of NJMoneyHelp.com. Stay informed and sign up for NJMoneyHelp.com's weekly e-newsletter.