New Jersey is one of the six states that has an inheritance tax.[1] This means that if you live in New Jersey (or if you own property in New Jersey), the beneficiaries of your estate may need to pay a tax depending on how much they inherit, what type of asset they inherit, and their relationship to you.
Who is exempt and who has to pay?
Class A beneficiaries are exempt from the inheritance tax. Class A beneficiaries are your spouse, children, stepchildren, grandchildren, parents, or grandparents. They do not have to pay an inheritance tax in New Jersey. This means that not all of your relatives are Class A beneficiaries. You may love your niece as a daughter, but she could be subject to an inheritance tax if you leave her a part of your estate in your Last Will & Testament or Revocable Living Trust.
Class C[2] includes your siblings and your son in law (or daughter in law). The first $25,000 is exempt, but anything more than that is subject to a tax that starts at 11% and is based on a graduated scale.
Class D beneficiaries include everyone else who is not in A, C, or E. Your nieces, nephews, friends, or significant other are Class D. There is a $500 exemption after which they have to pay at least 15% on any inheritance which is subject to the tax.
Class E beneficiaries are tax exempt entities such as charities. They do not have to pay an inheritance tax.
What Assets are Subject to the Inheritance Tax?
Most assets are subject to the inheritance tax including bank accounts, IRAs, real property, personal property. Life Insurance, however, is not subject to inheritance tax in New Jersey.
Notable Exceptions
Interestingly, Life Insurance is not subject to Inheritance Tax. Payments from certain pension plans such as the New Jersey Public Employees Retirement System, the New Jersey Teachers’ Pension and Annuity Fund, and the New Jersey Police and Firemen’s Retirement System are not subject to Inheritance Tax. Also, in New Jersey, there is no inheritance tax on gifts made during lifetime so long as the gifts were made 3 years before death
How Does this Impact Your Planning?
Since not everyone is subject to an inheritance tax and among those who are, not everyone is subject to the same rate, it would be wise to consult with a specialized estate planning attorney when creating your estate plan so that you can maximize the amount of money going to your beneficiaries and minimize the amount going to taxes. Additionally, it would be important for your beneficiaries to know who has to pay the inheritance tax – by making the estate pay the taxes out of the residue, it would make it easier for the Executor to administer the estate as he or she can avoid chasing after the various non-Class A beneficiaries to pay up, but it also would mean that less money would go to the residuary beneficiaries.
Example:
Bob is a widower. He and his late wife never had children, but he has two siblings, two nephews, and three close friends who he would like to include in his Will. He would like to give his seven beneficiaries 1/7 of his total $500k estate.
Half of Bob’s estate comes from his life insurance policy; in which Bob had named his wife as the beneficiary but never updated it when she died, nor had he named any contingent beneficiaries. This means Bob’s estate became the beneficiary upon his death and his seven beneficiaries now have to pay inheritance taxes on their respective shares
Result: Each beneficiary inherits $71,428, but the siblings would only have $66,321 after taxes and the other beneficiaries would have $60,714 after taxes. Out of the $500,000 estate, $63,784 or 12.7% will go to the State.
What could Bob do differently?
If Bob goes to an estate planning attorney, the attorney can advise Bob that his beneficiaries are subject to an inheritance tax, and that his nephews and friends are subject to a greater tax than his siblings.
With this awareness, Bob can be more strategic in how he distributes his estate, can reduce the total amount paid in taxes, and can allow for each beneficiary to inherit more money.
Instead of splitting the estate in 7 equal parts, Bob can split his life insurance amongst his five class D beneficiaries, giving each one 20% of the policy. To make it up to his siblings, Bob can give each sibling 30% of his estate and divide the remaining 40% amongst the class D beneficiaries, giving each one 8% of the estate.
By doing this, each sibling will receive $69,500 instead of $66,321, and the nephews and friends will receive $67,000 each instead of $60,714. Out of the $500,000 estate, only $26,000 or 5.2% goes to taxes.
Conclusion
An estate planning attorney can help you achieve the best results for your beneficiaries. Not only would the attorney have advised Bob on proper titling of all probate and non-probate assets but could have helped ensure which beneficiaries inherit what amount and from where. Just splitting the estate equally might sound fair, but as you saw with Bob, it created a not so great outcome for all of his beneficiaries.
[1] Iowa is phasing its out and is set to be gone by 2025.
[2] Class B no longer exists.