New Jersey residents must be concerned with two types of taxes, the first being the New Jersey inheritance tax, and the second being the federal estate tax.

The imposition of a New Jersey tax depends upon the relationship between the decedent and the beneficiary. Anyone who is a spouse or a lineal defendant of the decedent is considered a "Class A" beneficiary, and no tax is imposed on the inheritance regardless of its size.

The federal estate tax has three important exemptions. First, anything which passes outright to a surviving spouse, or in a qualifying trust for the sole lifetime benefit of a surviving spouse, is always free of estate tax. Second, anything which passes to a qualified charity is exempt from tax. Thirdly, any assets which pass to any other beneficiary up to a total of $675,000 are all exempt from tax. It is important to note that this exemption of $675,000 is per decedent, not for each individual beneficiary.

After the $675,000 exemption, the balance will be subject to an estate tax at a marginal rate that starts at 37 percent.

Until the tax act of 2001, the applicable exclusion of $675,000 was scheduled to eventually increase to $1 million by the year 2006. However, with the changes in the tax act of 2001, the applicable exclusion goes from $675,000 in 2001 to $1 million in 2002, and will eventually increase to $3.5 million in the year 2009. In 2010, the exclusion is unlimited so that the estate tax will be repealed. However, due to a political compromise, the estate tax comes back in the year 2011, with a $1 million exclusion.

The amount of the applicable exclusion is dependent upon the year of death.

Some married couples take a false sense of security from the fact that anything that passes to a surviving spouse is exempt from tax. This is actually a trap for the unwary. If the first spouse to pass away leaves everything to the surviving spouse, then the surviving spouse will own all of the assets which the couple accumulated. Upon the death of the surviving spouse, the first $675,000 will be exempt from tax (or whatever the applicable exclusion is for that year), and the balance will be subject to a tax starting at 37 percent.

As an alternative to leaving everything to the surviving spouse, it is usually preferable for the first spouse to leave assets in trust for the benefit of the second spouse with a provision that the surviving spouse will have a right to a stream of income for life. Upon the death of the second spouse, the assets and trusts are not included in the taxable estate of the surviving spouse.

Through this arrangement, a married couple can combine their exemption, and leave a total of $1.35 million free of federal estate taxes to the next generation. If the total assets are $1.35 million or more, this will save the family at least $250,000 in federal estate taxes.