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How To Get State Death Tax Relief

March 11, 2014
by Jack Reynolds

Fortune CookiesWhen it comes to financial and estate planning, U.S. residents tend to focus more on federal tax planning than on state tax planning, and for good reason. Federal estate taxes (sometimes referred to as a transfer tax) can be burdensome on very large estates. However, some people may have to pay both federal estate taxes and state estate/inheritance taxes (also referred to as death taxes). Paying taxes at both the federal and state level can be quite substantial. With careful planning however, there can be opportunities for significant savings.

State estate and inheritance taxes tend to have a relatively greater impact on moderate-sized estates than on very large estates. For example, if you are a married couple with a $10 million estate, with proper planning you may not have to pay any federal estate tax, but your state estate/or inheritance taxes may be significant. If you live in New York or Massachusetts for example, you are likely to pay a $1.44 million estate tax. If you happen to live in New Jersey, you may have to pay both a $1.5 million estate tax and your beneficiary may have to pay a $1.6 million inheritance tax.

This week’s article, discusses some of the choices you have for gaining attractive death tax relief, regardless of the state in which you live.

What Is a Death Tax?

The term death tax is a colloquialism used by non-professionals to refer to estate, inheritance and gift taxes. They are also referred to as transfer taxes. What are the differences among these three taxes? For the sake of simplicity let’s think of them this way:

  1. Estate taxes are paid by an estate before the estate’s assets are transferred to its non-charitable beneficiaries. Estate taxes are levied at the federal level and by some states.
  2. Inheritance taxes are paid by the non-charitable recipient of the assets from an estate-transfer. In the U.S. there is no federal inheritance tax.
  3. Gift taxes are borne by the living donor of a lifetime gift to a non-charitable beneficiary. Since only two states (Connecticut and Minnesota) have a gift tax, the concept is largely applicable at the federal level.

Why Focus on State Death Taxes?

Federal gift & estate and state estate/inheritance taxes can have a big impact on your estate and/or your beneficiaries. Currently, the federal government offers a relatively generous gift and estate tax exemption of $5.34 million per person, or $10.68 million per couple. However, this exemption is operative to varying degrees (or not at all) in the 19 states and D.C. that have estate and inheritance taxes. New York’s estate tax exemption for example is just $1 million.

  • Minimizing federal estate and gift taxes is a topic that applies primarily to the very wealthy.
  • Minimizing state estate and inheritance taxes is a topic that applies to a much larger group of persons, both the moderately well-to-do and the very wealthy.
  • Hence, a lot more persons need to plan around state death taxes than need to focus on federal estate and gift tax planning.

How to Avoid Death Duties in High Tax States

About one third of the U.S. population resides in the 19 states/D.C. that have estate and/or inheritance taxes. However, two thirds of the U.S. population lives in the 31 states that do not have these tax burdens (sometimes referred to as tax haven states). In order to qualify as a resident of a tax haven state, you must live there at least six months a year (consult your adviser for specifics).

If you reside in a state that has death taxes then you might consider one of the options below:

  • Move. Do you like snowy winters? Then consider moving to New Hampshire, Michigan, Wisconsin, the Dakotas, Montana, Idaho or Alaska, which have no state estate or inheritance taxes. On the other hand, if you are a sunbird, then the entire Sun Belt is open to you. From Virginia to Florida and from Florida to California (excluding Tennessee), these states also have no death taxes.
  • Have Multiple Residences. If you are a part of a couple and one of you wants to move to a tax haven state while the other does not, this too can be arranged. A client has taken this approach and although it requires careful planning and good recordkeeping, it is not out of the question. Be aware that the estate of the person who continues to reside in the non-tax haven state will still be subject to that state’s death taxes.
  • Become a Nomad. You might be wondering, “Hey Jack, instead of moving my residence to a low tax state, why don’t I just travel for six-plus months a year, or perhaps hike the Pacific Crest Trail?” Well you can certainly do that, but most states do not allow you to stop being a resident (and avoid their death taxes) until you become a bona fide resident of another state. The nomad strategy is unlikely to be successful, and each situation is fact- specific, so be sure to consult your advisers.

Lifetime Gifts – A Great Way to Reduce Your State Death Taxes

If you reside in a state with estate and/or inheritance taxes, is there anything that you can do to ameliorate your state death tax burden? Happily, the answer is: yes, by making lifetime gifts to your non-charitable beneficiaries. Unlike estate transfers, gifts made during the lifetime of the asset holder are not taxed at the state level upon transfer to the beneficiary (except in Connecticut and Minnesota). So be generous to your beneficiaries during your lifetime to reduce your death taxes (just be sure to keep enough to live on).

The federal tax system has no such loophole for lifetime gifts, as federal taxes are levied upon non-charitable gifts (above the exemption level) regardless of whether the transfer is made during your lifetime or after your death. If you have exhausted your federal lifetime gift tax exemption, are state tax-free lifetime gifts a ‘no-brainer?’ If you are a regular reader of my articles, then you will know that I have previously made a strong case for lifetime gifts that are taxable at the federal level. In fact, I encourage them. See my earlier article, The Advantages of Making Taxable Lifetime Gifts.

Managing Taxes on Non-Cash Gifts

As you have seen, transferring assets can affect death taxes on both the estate and beneficiary. Transfers can also affect income tax considerations, especially for non-cash gifts. For example, if you transfer a non-cash gift that has appreciated (e.g., securities, business interests or property), then your beneficiary may have to pay a significant capital gains tax if and when they sell it. Fortunately, the capital gains tax problem can be reduced through careful planning and analysis of the tradeoffs between death-related taxes and capital gains tax. Consult your advisers, since as each situation is fact-set-specific.

Recommended Reading to Learn More

You may wish to find out more about the topics I have addressed above and review a table of estate and inheritance taxes, exemptions and top tax rates by state. If so, see States You Shouldn’t Be Caught Dead In by Laura Saunders, in the Wall Street Journal of October 26, 2013, at page B-7. It is most important that you is consult professionals who can assist you with financial and estate planning.

If you have a comment on this article, please use the comment box below. Leaving comments allows readers to expand upon the topics covered in my articles. So please help us all by commenting. If you would care to discuss financial and investment planning with me personally, please drop me an email or give me a ring at 617.945.5157.