Don’t Underestimate State Estate Taxes

The implications of this often overlooked tax

01.15.2021 - Brian Conboy, Director of Estate Administration, Trust Counsel

Today’s federal estate tax exemption is generous by historical standards. However, families residing in any of the 17 states and the District of Columbia that levy state estate or inheritance tax should not be complacent. Brian Conboy, Director of Estate Administration and Trust Counsel, examines the potential impact of state estate taxes on an inheritance. 
Q. What is the difference between federal and state estate and gift taxes? 

BRIAN: While there has been a lot of discussion about federal estate taxes over the past several years, state estate taxes have often fallen under the radar. At the federal level, each of us may transfer—either during lifetime or at death—up to $11.7 million in 2021 (adjusted annually for inflation) free from federal gift and/or estate tax. Any amount over the federal exemption is taxed at a maximum 40% federal estate tax rate. 

Many states impose separate state estate, gift and/or inheritance taxes on assets transferred during lifetime or at death. Until 2005, most states simply received a share of the federal estate tax in the form of an estate tax credit (also called a “pick-up tax”), so no additional burden was felt by most families. However, under the 2001 tax act, the state estate tax credit was slowly phased out and was replaced with a less valuable estate tax deduction. As a result, many states lost an important revenue source. In response, a number of states “decoupled” from the federal system and enacted their own separate transfer tax systems. Today, 17 states including Connecticut, Massachusetts, Maine and New York, plus the District of Columbia, levy state estate or inheritance taxes, and the rates can be as high as 20%. 

Q. What impact can state estate taxes have on an inheritance? 

BRIAN: State estate taxes can have a meaningful impact on an inheritance, particularly when the family expects that no tax will be due at the death of the first spouse. While the federal exemption is quite high, states will often tax much smaller estates. For example, Massachusetts and Oregon only exempt $1 million from state estate and inheritance tax. Exemption levels in several other states range from approximately $1.5 million in Rhode Island in 2021 up to $5.93 million in New York.  

To put this into dollar terms, an Oregon resident who dies in 2021 with a $11.5 million estate will owe no federal estate tax. However, since any assets that exceed the $1 million Oregon exemption threshold are taxed, the estate could owe over $1 million in Oregon state estate tax.  

Q. Can families living in states without estate tax be affected? 

BRIAN: Absolutely. Residents of states that do not impose a state estate tax should not be complacent. First, if an individual owns property in a state with an estate tax, such as a vacation home, the family may be subject to a non-resident estate tax. Second, tax laws can and do change. Within the last few years, some states including Illinois, Delaware and Hawaii have re-enacted or made permanent their separate state estate tax laws. Other states have modified their existing laws, either by increasing or reducing the amount that can pass free from state estate taxes. Rates may also change—for example, Washington raised the top four estate tax rates by 1%, bringing the highest marginal rate to 20% on taxable estates in excess of $9 million. 

Q. Since state and federal estate tax exemption levels differ, how can families best make use of both exemptions? 

BRIAN: For many families, maximizing the use of the federal exemption through the use of a credit shelter trust funded with the current federal exemption amount remains a priority, even if such a plan would require that a state estate tax be paid at the death of the first spouse. 

Others may wish to avoid or minimize state estate taxes at the first spouse’s death. In that case, there are several planning options which may involve the use of qualified disclaimers, limiting the credit shelter trust to the state estate exemption, planning for the “gap” amount between the state and federal estate tax exemptions by utilizing marital trusts and/or maximizing the use of any state Qualified Terminable Interest Property (QTIP) elections. We recommend speaking with your Fiduciary Trust relationship manager or estate planning attorney to determine the most appropriate strategy for your particular situation. 

Q. Can married couples combine their individual exemption amounts? 

BRIAN: Yes and no. Federal law allows for “portability” of federal estate and gift tax exemptions between spouses. In simple terms, if an individual dies without having used his or her full federal estate tax exemption, the unused exemption can be used at a later date by his or her surviving spouse, provided certain elections are made on the decedent’s estate tax return. 

That said, portability does not necessarily apply to state estate, gift or inheritance taxes, nor does it apply to the federal generation-skipping transfer (GST) tax exemption. While portability may simplify estate planning at the federal level, it may result in a substantially higher state estate tax bill at the surviving spouse’s death plus additional taxes on distributions to grandchildren at a later date if one’s GST tax exemption is not utilized. 

Q. Can lifetime gifts help to reduce state estate taxes? 

BRIAN: Yes, lifetime gifting is a great option for individuals seeking to reduce their overall estate tax bill. Since most states do  not impose a state gift tax, most people can reduce their state estate tax bill by making lifetime gifts. In most cases, assets transferred during life will not incur a state level gift tax and will not be subject to state estate tax at the donor’s death. Of course, we recommend that our clients consult with your estate planning attorney before making substantial lifetime gifts.

This communication is intended solely to provide general information. The information and opinions may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.



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