The history of estate taxes in the United States is convoluted, and that is an understatement. There is little point in reviewing all the various changes federal estate taxes have gone through over the decades aside from pointing out the taxes that used to be imposed on estates large enough to be taxed were so high that avoiding federal estate taxes was the main reason many people did estate planning. Paying 40% or more to the federal government made paying any state-imposed estate taxes at their much lower rates seem like small potatoes. The objective, then, was to reduce federal estate taxes, and any state estate taxes paid were considered small enough in comparison to not be a major concern.
Federal and state estate taxes were calculated on roughly the same sized estates back then, so if you were taxed at the federal level on amounts above $1M, you were frequently taxed a second time by the decedent’s state of residence at a lower rate on the same amount. Now, however, estates at the federal level have to be worth more than around $11.4M, and a married couple gets to pass on a full $22.8M to their heirs before the first dollar is taxed. With the federal exemption set so high, far, far fewer people worry about having to pay the federal estate tax any more. In fact, we all wish we had to worry about that problem. That’s the good news.
The bad news, however, is many states did not raise their exemption levels to anywhere close to the federal level. For example, Massachusetts still taxes estates above $1M, and Rhode Island above a little over $1.5M. Getting taxed at up to 16% seemed so much less than the 40% in years past, but it still results in a 16% reduction, or close to that, for what many people intend to pass on to their heirs. Now that the 40% potatoes are nothing to worry about, we’re finding that 16% estate taxes are also not exactly small potatoes.
Let’s consider the situation where a spouse dies and passes everything on tax-free to a surviving spouse and then that surviving spouse eventually dies and passes everything on to their children. With $500,000 in home equity, $100,000 in insurance policies, and $1,000,000 in financial assets, the estate would lose nearly $96,000 to Massachusetts state estate taxes. That’s not as bad as paying 40%, of course, but still, $96,000 is a lot of money.
To reduce or avoid that 16%, investors have a variety of options. However, the solution is very dependent on the structure of the estate, the surviving spouse’s income needs, etc, so we cannot say any one solution is the answer for everyone. Just know there are ways to reduce or avoid state estate taxes, they would need to be tailored to each investor’s specific situation, and your Cadence advisor is able to help discover the best way to proceed.
Though the high federal percentage may be avoided, giving up to 16% of your estate away is still probably enough money to make estate planning a prudent activity.
Editors Note: This article was originally published in the October 2019 edition of our “Cadence Clips” newsletter.
