To any one of a number of government entities the average person can be boiled down to one category: We are revenue-generating machines. Federal, state and local government entities know how to get their funding, as it seems almost every aspect of life (and yes, death too) is now taxable. And next to actually having to pay all these taxes, the most frustrating thing about taxes are that they are never as intuitively straight-forward as one would suspect.
I met with a couple recently who is domiciled in New York. Their net worth is approximately $8,000,000, they are semi-retired, and their retirement income is substantial. Assets include a nice Manhattan apartment, a large sum of money in several retirement plans, a few well-funded permanent life insurance policies, and some jointly owned bank and brokerage accounts. They appear to have not had a decline in their net worth for more than two of the last twenty years. They want to continue living in their Manhattan apartment where they can easily visit their children and grandchildren, When I first met them they figured their gift and estate tax planning was simple: If they approached the federal exemption they would gift annual exclusion gifts to their family members and that would be that: They figured that no major estate tax planning necessary, but wanted to make sure they actually had escaped the tax collector’s last swipe at their assets.
For the better part of fifteen years the somewhat-well-to-do crowd was bombarded with information regarding the federal estate tax rate and exemption: In 1999 the Internal Revenue Service assessed taxes at a top estate tax rate of 55% after a $650,000 exemption. Between 2011 and 2013. Financial planners, accountants, and estate attorneys reaped large end-of-year consultation fees because of last-minute estate tax uncertainties: These professionals worked up to the chants of Auld Lang Syne, but were able to afford the hot Holiday gifts they had always promised their loved ones but may have never before been able to afford.
Remember that my new clients live in New York City: While few people will shed a tear for the poor couple teetering on a net worth of eight figures, they are hardly considered wealthy in this neighborhood, paying income, real estate and sales taxes that would make most people nauseous. Not to mention the $5 they have to spend for a cup of coffee or bottle of water. In Manhattan an $8,000,000 net worth means you are middle class.
Fortunately, Congressional wrangling finally gave the middle class citizen / tax generator a break and passed the American Taxpayer Relief Act of 2012 (on January 1, 2013, mind you). This effectively pegged the Federal exemption at $5,000,000 for 2011, adjusted it for inflation, and in 2013 established a flat estate tax rate of 40% on any assets in excess of this amount. And this amount seems, at least in some people’s estimation, fair: My middle class Manhattanites are not traveling on first class flights, and should rightfully not have to pay the same amount of taxes their penthouse neighbors are paying.
Thus the estate tax morass was fixed, and everything in the tax world was easy and predictable……unless you are domiciled in one of the 15 states that collect an estate tax. Or the 6 states with an inheritance tax. And to our over-achievers in New Jersey and Maryland, congratulations: You make both lists. So while my new clients would avoid a federal estate tax, they do not necessarily avoid paying estate taxes after all: The state will want its pound of flesh – the state estate tax is the federal estate tax’s silent twin who is now making itself known.
As planners, the fact that there actually is a state estate tax is merely the starting point in our calculus, since the actual state estate tax rates are far less than the 40% the IRS incurs. The real issue is that these states often have a much lower exemption amount than the federal government, I.e. you pass less money at death before the tax is imposed. Sure, many planners are happy to work with a couple facing a federal estate tax issue: Their net worth would be in excess of $10,860,000. In reality, most of us have many clients worth less than that who nevertheless do face a state estate tax or inheritance tax.
Of course, my new clients were in for a surprise. I explained that New York is an estate tax state, that there is no inheritance tax, and their tax situation was only a paused ticking time bomb. The estate tax rate in New York begins at around .8% and works its way up to 16%. Last year Albany decided to raise the state’s exemption amount to $2,062,500, at which point there would be an estate tax…provided the estate was 5% over this amount…in which case it could possibly face a “cliff tax” making the whole amount taxable (I can’t make this stuff up – reality can be crazier than myth). New York’s estate tax exemption amount did increase to $3,125,000 recently (see above for how this may or may not make sense), and does gradually increase to match the then-current federal exemption amount is 2019, so I told them to make sure to look both ways before they cross the street until 2019, and all would be fine.
However, what if a spouse passes away before 2019 when the state exemption amount is not yet equal to the federal amount? Or even if they do live into 2019, how does one plan to maximize these exemptions? And then there are wild card issues: If the couple’s join assets are less than $10,860,000 and they have properly set up credit shelter trusts, what if they have named their spouses as the sole beneficiary on their retirement plans (which often happens)? Or what if the life insurance policy’s beneficiary was never changed to the credit shelter trust? In addition, New York does not recognize estate tax portability for a first-to-die spouse who did not do proper planning, so even a slight mistake may cause excess assets to be included in the estate of the second spouse to pass away. What then?
While my intention was to inform this couple, they were thrusted into a maelstrom of facts, details and uncertainty, and began wondering aloud whether it was worth just paying the state estate tax so they could go to sleep at night without worrying about all the variables now swimming in their heads. Of course, this is not a suitable answer for planners, and the inherent fear and defeat taxes invoke in clients who have saved their assets should always be addressed by providing creative answers to near-term action steps and flexibility for future events that are not yet known in detail.
The state estate tax plan begins with how to handle the certainties we can control: Primary beneficiaries on retirement plans should be reviewed to ensure continued creditor protection, placing joint assets into trusts should be confirmed in order to maintain an exemption for the first spouse to pass away, placing the Deeds to real estate into trusts should be coordinated, and making a credit shelter trust the primary beneficiary for a life insurance policy should be discussed when the survivor feels comfortable she will not need the principle and can live satisfactorily on income.
The focus then shifts to how to manage future situations where exemption amounts are unknown, which often happens when the approximate date of a person’s death cannot be predicted. One trustworthy strategy has been to leave the majority of assets directly to the surviving spouse or her trust, then exercise disclaimers to the deceased spouse’s credit shelter trust (sometimes called a “Disclaimer Trust”). Retirement plans could also be left first to the spouse, then naming a see-through trust for children as the contingent beneficiary. These methods worked in the past, when federal and state estate tax exemptions required even greater post-mortem planning (due to constantly changing and differing exemption amounts, federal and state estate tax rates, etc.), and should continue to work for couples who are on the cusp of state estate tax issues.
In addition, in a few circumstances it may make sense to decrease the size of an estate by converting retirement plans to Roth IRAs, thereby decreasing the amount that may be taxable for estate tax purposes (but beware: the highest state estate tax rate is 20% for the largest estates in Washington state, which is still probably lower than the income tax rates that will be assessed on the conversion). Lastly, many states do not have any gift taxes; while capital gains taxes are the new “hot topic” for tax planning in this era of high estate tax exemptions, gifting non-appreciated assets early to 529 Plans, UTMAs, and other vehicles still has relevance to those people facing state estate taxes. The use of irrevocable trusts is not necessarily off the table, but a decision has to be made whether the costs associated with staying in compliance (creation of additional tax returns, Crummey Notices, etc.) negates the benefits.
In summation, the state estate tax discussion has to be answered first by giving full disclosure of the facts. What is the nature of that state’s estate, inheritance and gift tax structures? Are any assets highly appreciated? Is a spouse willing to limit themselves to income from a credit shelter trust? And, sometimes the surprising question is answered in the negative: Does the client even care about planning for the somewhat low state estate tax liability? These clients did, but before we became willing to commit to implementing the suggested course of action they had to be made aware of the savings and expenses involved, the work that would be required in the short term, and the fact that future action would have to be addressed as those laws change.
Your clients ignore state estate taxes at their own risk, become informed of them with their attentiveness, and may not pay them at all if you knowledgably guide them through the tax saving process.