Edith Windsor was prominent at the Supreme Court hearing on the Defense of Marriage Act in March. Ms. Windsor married her same-sex partner, Thea Clara Spyer, in 2007. When Ms. Spyer passed away in 2009, she left her entire estate to her spouse, Ms. Windsor. Because federal law does not recognize same-sex marriages, Ms. Windsor was required to pay federal estate tax of more than $363,000. Fortunately, they lived in New York State which does recognize same-sex marriages; otherwise New York would have added another $500,000 of death taxes to the bill.
State estate and inheritance taxes can come as a big surprise for taxpayers in 21 states and the District of Columbia where separate state levies are still a big concern. Thanks to the fiscal cliff tax deal, the federal estate tax only hits individuals who die with more than $5.25 million of assets (2013 – indexed for inflation). Some of the states with inheritance taxes offer no exemptions. The inheritance tax starts on the first dollar. States with estate taxes typically exempt $1 million or less per estate from their tax and impose a top rate of 16%. Two states, Maryland and New Jersey, impose both. Maryland imposes an estate tax of up to 16% above a $1 million exemption, and a 10% inheritance tax on every dollar left to a niece, nephew, friend or partner, but no inheritance tax on money left to children, grandchildren, parents or siblings. Yikes!!!
However, with a little planning you may be able to make the state tax bill go away. Here are some recommendations:
There are 29 states without a death tax. Some of them probably have a very nice climate. You cannot merely state that you are changing your legal state of residency and stay in your former state. You’ll need to provide proof you are a resident of another state. This is usually evidenced by changing your driver’s license, registering to vote, and changing your automobile registration to the new state. Be sure to have your will updated stating you are a resident of the new state.
Every taxpayer can give $14,000 a year (2013 – indexed for inflation) to as many people as they like without federal gift tax. Connecticut is the only state with a gift tax on cumulative gifts over $2 million. Gifts can be made into a trust for those concerned about recipients squandering the money. The trust must be irrevocable and the donor cannot have control for the trust to be considered a completed gift. The gifts must be outright gifts with no strings attached
Review your estate plan
It was not long ago when the federal estate tax exemption was $1 million. To stretch this exemption, married couples would establish credit shelter trusts (also called bypass trust or A/B trusts) to protect the $1 million exemption of the first person to pass away. The American Taxpayer Relief Act of 2012 made the federal exemption portable. The credit shelter trust is no longer needed for the federal estate tax but it is still a viable strategy for residents of states with an estate tax and a $1 million exemption. $1 million from the estate of the first spouse to die goes into the bypass trust and is exposed to tax. The exemption shelters this transfer from tax. The trust holds the funds to ultimately go to the heirs but the income can be paid to the surviving spouse until their death. With this strategy, no state taxes are paid at the first spouse’s death
Use Life Insurance
Leave your assets to charities and set up an irrevocable life insurance trust for heirs. This strategy calls for setting up a trust to hold a life insurance policy on your life and gifting the premiums to the trust each year. The policy pays the trust upon your death and the proceeds are distributed to the heirs. Your assets pass to charity outright tax-free. The cost of life insurance will play an important role in determining the effectiveness of this strategy. If the premiums are too expensive either because of age or health it may be cheaper for the heirs to pay the estate/inheritance tax.
Your estate plan should include a provision to deal with your state’s death tax. You should consult with your estate planner on other ways to deal with this important issue.