Another State Ditches Its Death Tax While Potential Backdoor Federal Estate Tax Looms

In a sign of the political divide over death taxes, Iowa is repealing its inheritance tax, with a phased-in reduction of the tax bite retroactive to January 1, and full repeal as of January 1, 2025. Abolishing the state inheritance tax was a key priority for Republican Governor Kim Reynolds; it was part of a larger tax cut package that speeds up income tax cuts signed into law earlier this summer.

Iowa’s inheritance tax repeal comes along while proposed federal death tax changes could mean many more estates will face federal taxes at much lower wealth levels.

Iowa’s move will leave five states with an inheritance tax, and 11 states and the District of Columbia with an estate tax (See Where Not To Die In 2021 for the full list). Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania are the other inheritance tax states. Maryland has the dubious distinction of having both an inheritance tax and an estate tax. Iowa’s repeal makes Nebraska “a clear geographic outlier,” notes Sarah Curry, policy director with the Platte Institute.

If you live in one of these states, it’s essential you review your estate plan to avoid surprises for your heirs—not just taxes due but administrative hassles. In New Jersey, for example, leaving a $2,500 bequest to a brother in your will triggers the requirement to file a 22-page inheritance tax return—even though no taxes are due. Leave $727,000 to a niece or nephew and the New Jersey inheritance tax owed is $109,240.

That inequitable treatment among heirs—the tax rate is based on the relationship of the decedent and the heir—is perhaps the biggest fault with inheritance taxes. Take Nebraska, for example. Nebraska taxes children and grandchildren at a 1% rate, nephews and nieces at a 13% rate and non-relatives at an 18% rate. In a report calling for an end to Nebraska’s inheritance tax, Curry notes that a life-long domestic partner is not recognized as a legal spouse by the state, and this means their gift from the decedent is taxed at the highest rate.

It’s not just the rich who need to pay attention. An Iowa Department of Revenue study found that 92.5% of inheritance taxes were assessed on households with adjusted gross incomes of $80,000 or below.

How much will Iowa’s inheritance tax repeal cost the state? The Iowa change reduces the tax rate by 20% per year over four years, and then eliminates the tax entirely as of January 1, 2025 (for deaths occurring on or after that date). Once repeal is fully effective, it will reduce state revenues by $100 million-plus a year, according to a Department of Revenue fiscal impact analysis.

State death taxes nationwide bring in revenues of around $5 billion a year altogether, according to a Center on Budget and Policy Priorities report (State Taxes On Inherited Wealth, Table 1). The authors, Elizabeth McNichol and Samantha Waxman, argue that to combat extreme wealth concentration and to “build a more broadly shared prosperity” that states with these taxes should maintain them, and states without them should consider enacting them or consider taxing inheritances as income.

Meanwhile, a bigger death tax battle is brewing at the federal level. The federal death tax levy is separate from the state levies. While the Trump tax cuts temporarily doubled the federal estate tax exemption to $11 million per person, virtually eliminating the federal estate tax for all but the wealthiest, two proposals could be used as revenue raisers for the Democrats’ $3.5 trillion soft-infrastructure spending package under discussion in Congress.

One, the federal estate tax exemption level could be reduced to $3.5 million per person. It’s set to go back to $5 million, indexed for inflation, in 2026 anyway. And two, a proposal to end “stepped-up basis” (with a $1 million exemption) would mean that your heirs would owe a 43.4% income tax on unrealized capital gains at your death. All 50 Senate Republicans recently penned a letter to President Joe Biden opposing this “new backdoor death tax.” They warned of “colossal implementation problems” and a significant tax increase that would hit family-owned businesses, farms and ranches, citing a study by the Texas A&M Agricultural and Food Policy Center that found 98% of farms in its 30-state database would be impacted, with average additional tax liabilities of $726,000 per farm.

Further Reading:

State Death Tax Changes Loom: Where Not To Die In 2021

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