For more than 100 years, the U.S. government has been taxing assets that remain upon death. Fortunately, over time, the government introduced exemption limits allowing a portion of these assets to transfer to a person’s heirs tax-free.
Over the last 20 years, the IRS increased the federal estate tax exemption from $1,350,000 to $23,160,000 for married couples. Because of these increases, many couples might falsely think they are safe from the estate tax. However, just because you are free of the federal estate tax does not necessarily mean that you do not have tax liability at the state level.
Many states have their own estate or inheritance tax on assets owned by residents. In many cases, the state estate and inheritance taxes offer exemption limits that are much less than those of the federal government. If you don’t start planning today for it, then you or your heirs could end up paying additional taxes later.
Defining State Estate and Inheritance Taxes
Currently, 17 states and the District of Columbia have either an estate or inheritance tax, or both.
- The estate tax is a liability paid at death on the total estate before distribution to its heirs.
- The inheritance tax is the responsibility of the beneficiary after receipt of the inherited property with the tax rate dependent on the familial distance from the decedent.
Both types of taxes have an exclusion amount that exempts a certain dollar amount from taxation. Since many of these state exemption amounts are significantly less than those of the federal government, residents in these states need to prepare for each in their estate planning.
Portability of the State Estate Tax Exemption
Of all states/districts that impose an estate/inheritance tax, only Hawaii allows portability of the exemption limit between spouses like the federal exemption does. Portability lets you pass any unused exemption amount to your spouse upon first passing. On the state level, most states do not allow portability. This requires additional planning, especially for those clients whose net worth is between a higher federal exemption limit and a lower state exemption limit.
How to Minimize State Estate and Inheritance Taxes
If your state has an estate or inheritance tax and your estate is valued at more than the quoted $11,580,000 federal exemption per individual ($23,160,000 per couple), then you might have to pay estate taxes at both the federal and state level. However, if your estate is below the federal exemption limit but above the domiciled state exemption limit, you can employ a number of different strategies to optimize the estate exclusions. In doing so, you can transfer more assets tax-free and minimize the amount above the exclusion that is subject to estate or inheritance tax. Among these strategies are:
Immediate Asset Spending
An easy strategy to minimize a potential estate tax liability is to spend assets today. Those with taxable estates can accomplish this by:
- Spending assets outright. The less assets available in your estate upon death, the less the tax liabilities for your estate and your executor.
- Gifting assets to family members or charities. You are permitted to gift up to $15,000 per donor and per recipient tax-free each year (not including charities). In addition, if you accelerate any charitable gifting, you can take advantage of the itemized deduction today while also reducing your taxable estate in the future.
Trust Planning
Trust planning is another way to minimize a potential estate tax liability in the future. The simplest option within trust planning is also the least costly: equalize the estates of both spouses.
Because most states with an estate or inheritance tax do not allow the transfer of any unused state exemptions, equalizing assets between two spouses allows couples to keep the maximum value of their estate free from tax while getting the most benefit from each individual exemption.
Examples of reducing the taxable estate through trust planning include:
Shifting of Assets — It is common for account totals to vary with contributions/withdrawals and market fluctuation, leading one spouse to likely accumulate more assets than the other, resulting in a higher potential for a taxable estate.
You cannot change the ownership of retirement assets, but you can modify the ownership of brokerage assets. You can shift these brokerage assets between spouses tax free by transferring funds from an account under one spouse’s name to an account under the other spouse’s name. This will equalize the assets in each individual’s estate.
In Scenario 1 below, an uneven distribution of assets results in a taxable estate.
If the same couple were to transfer funds from Spouse 1’s brokerage account to Spouse 2’s brokerage account (shown in Scenario 2), then each spouse would maximize their estate exemption limit, leading to the exclusion of more assets from the state estate tax.
In planning separately for the federal and state estate limits, a couple with assets under the federal exemption limit but at or over the state exemption limit can use planning techniques to minimize the taxable estate without the need for a complex trust.
ABC Trusts
If you are willing to pursue a more complicated option for trust planning, you could work with an estate planning attorney to draft and execute an ABC Trust. These trusts divide a deceased spouse’s estate into two parts:
- Assets equal to the federal (or state) exemption limit
- All other assets passing outside the person’s estate
ABC Trusts are a more costly option than the aforementioned, but they are helpful for estates over both state and federal estate exemption limits because they ensure each spouse maximizes his/her individual state and federal exemption amounts.
Relocation
Depending on where you plan to establish residency, relocation can benefit your tax situation in more ways than one. For those considering a change of residency in retirement based on property and income tax, another point to consider is state estate and inheritance taxes. States like Florida, Nevada and Texas have gained popularity for retirees because they not only avoid paying state estate tax but also state income tax as well. Here’s more on what to consider when relocating to saves on taxes.
Additional Resources
For information on how the CARES Act affects estate planning and Required Minimum Distributions, please refer to our blog, “Here’s How You Can Leverage Tax Savings and Other Planning Opportunities in a Volatile Market.”
For more information on these or any other family wealth topics, download our 2020 Financial Planning Guide.
We are here to help. If you have questions, please reach out to us directly, 770-368-9919, or email Cliff, cliff@cwoconner.com or Kevin, kevin@cwoconner.com.
Cliff is the founder and president of C.W. O'Conner Wealth Advisors, Inc. Cliff earned a Bachelor of Business Administration degree in Accounting from Georgia State University.
Kevin O'Conner is a financial planner with C.W. O'Conner Wealth Advisors, Inc. He earned a Bachelor of Business Administration degree in Business Management from Georgia College, and is a Certified Investment Management Analyst (CIMA).
