The inheritance tax is distinct and not to be confused with the estate tax, sometimes also known as the death tax. The estate tax is levied on an estate after its decedent has died. In contrast, the inheritance tax is set on the heirs receiving their respective portions of the estate in the final stages of the probate process.
Some states levy both a state inheritance tax and a state estate tax, in addition to the existing federal estate tax levied on all estates that exceed an individual exemption limit. California is not one of those states. California has neither its estate tax nor an inheritance tax. California’s estate tax was phased out over four years, starting in January 2002 and culminating in the total elimination of the state estate tax in January 2005.
The Inheritance Tax in California
You don’t have to worry about an inheritance tax in California when passing on assets. However, there are other tax implications to keep in mind. Distributing assets among your loved ones may trigger the California generation-skipping transfer tax. The generation-skipping transfer tax is a federal tax, as well as a state tax in California.
However, this tax only applies when the amount transferred exceeds $12.06 million per individual and if your gift or inheritance recipient is 37 and a half years younger than you. As such, the state GSTT and the federal GSTT are something most American taxpayers never need to worry about.
The purpose of the generation-skipping transfer tax was to close a loophole that allowed wealthy Americans to distribute assets to their grandchildren or great-grandchildren without double taxation. Usually, passing on wealth beyond the exemption limit of the estate tax would trigger the tax twice before it reached an individual’s grandchildren – once by passing onto the target heir’s parents and again by passing onto the target heir.
In practice, the GSTT would ensure that the bequeathed amount would be equal to its value if given to the parents first by applying a flat tax rate twice. Aside from this example, the state of California itself does not impose additional taxes on estate bequeathments or lifetime gifts, but the federal government does.
The Impact of the Federal Estate Tax
The federal estate tax has a flat tax rate applied to all estates that exceed the individual or joint exemption limit, adjusted for inflation each year. In 2022, the exemption limit for the federal estate tax is $12.06 million, like the limit for the GSTT. This exemption limit coincides with a person’s lifetime gift tax exemption, up to a certain amount, meaning if you gift, this limit will remove more than the annual limit of $16,000 (in 2022).
A person can whittle their estate tax exemption limit to an insignificant sum by making excessive gifts each year. However, it takes many gifts to give to eliminate the current exemption limit. This will also affect your final estate tax exemption limit will. The flat tax rate on estates exceeding the exemption limit is 40 percent.
This matches the GSTT, as the point of that tax is to double-tax an inheritance skipping one or more generations. Most estates do not qualify for the federal estate tax. However, that may not always be the case. The estate tax exemption limit was not always this high. The Tax Cuts and Jobs Act of 2017 only recently increased it to over ten million.
The Future of the Federal Estate Tax
The exemption limit on the estate tax was as low as $675,000 as recently as 2001. It increased to a million in 2002, adjusted for inflation in 2003, and then rose again to $1.5 million in 2004. The government increased it to $2 million in 2006, $3.5 million in 2009, and $5 million for decedents dying in 2011.
Since then, it has been on a sharp incline, with the most significant jump between 2017 and 2018 ($5,490,000 and $11,180,000, respectively). President Biden has made statements intending to considerably cut back on the current estate tax exemption limit, meaning more Americans may be affected by estate taxes by the end of his term than today.
However, the changes to the estate tax limit in 2017 are not a part of permanent tax law. The government will likely reverse the changes in 2025, causing estate tax exemption limits to revert to pre-2017 levels. A proper estate plan can significantly minimize your tax liability by changing how the government distributes your belongings after death and how you manage your belongings in life.
For certain taxpayers with wealth close to the current exemption limit, for example, estate professionals may recommend an irrevocable trust to try and separate certain assets from their estate, thereby reducing the size of their taxable estate. As such, you will want to prepare accordingly.
For Americans with modest wealth, for example, future changes to the estate tax limit may subject their estate to a significant tax rate before it reaches their children and grandchildren – especially after the family receives a life insurance payout. Trusts can be used to eliminate the impact a life insurance payout might have on an estate’s total value without robbing your heirs of the payout itself.
Is There a Federal Inheritance Tax?
The state levies an estate tax on an estate before distributing it among its heirs. The inheritance tax is a state tax that the government imposes on the inheritance when an heir receives it. California does not have an inheritance tax, and neither does the IRS. Only 17 states currently have an inheritance tax or an estate tax.
Some of them have both, and some have only one or the other. Tax rates on state estate taxes and state inheritance taxes are much lower than the federal estate tax rate of 40 percent – they hover between a fraction of a percent and up to about 20 percent for certain estates.
If you are a resident of California and wish to minimize the tax impact of your death, it’s crucial to be forward-thinking. The process is extremely complex, and you’ll likely need questions answered. Consult a local tax professional on potential tax hikes and considerations for the near future and plan your estate accordingly.