Many people thought their estate-tax worries were over once President Bush signed estate-tax relief in 2001. The law gradually increases the amount of your estate that's exempt from federal estate taxes, then eliminates the tax in 2010, before the tax comes roaring back to life in 2011 (unless Congress extends the relief law).
But that law didn't ease a related pain: your state's estate tax. You still must do some smart tax planning to minimize that tax. In some cases, you may find it even pays to move to a different state!
New incentive for state increases
Before 2002, when a person died, a credit for state taxes paid reduced his or her federal estate-tax obligation. Many states adopted a "pick-up" tax, so they would pick up the credit amount as their own estate tax.
Pre-2002 example: Say a person who died in 2001 owed $2 million in federal estate tax. The top rate for the credit was 16 percent, so the estate's executor would send $320,000 (16 percent of $2 million) to the state. The executor would then send the IRS the remaining $1,680,000 ($2 million total tax minus $320,000 state payment). Bottom line: The estate still paid the same $2 million, so it made no difference which amount went in which direction.
But the 2001 law phases out that credit.
In 2004, the maximum credit sits at only 4 percent, a quarter of its earlier size. And the credit will disappear after 2004. That means states stand to lose huge amounts in estate-tax revenues. In response, many states passed new estate tax laws and others are likely to follow in search of much-needed revenue.
What this all means: Your state's estate tax now costs real money—it's no longer just a trade-off between paying the feds or paying the state.
What's more, some estates will owe estate tax to their states, even though they owe no federal estate tax.
For example, someone dying in New York in 2004 with a $1.5 million estate would owe no federal tax. Reason: The 2004 federal exemption is $1.5 million this year. But that same estate would owe estate tax on $500,000 worth of assets to New York state, which held its estate-tax exemption at $1 million.
Ease your tax pain
That means you need to keep up your estate planning, even as the federal tax becomes less onerous.
Say you live in New York. You can leave $1 million to your children (or to a trust for your children), an amount that's exempt from state as well as federal estate tax. If you leave your children $1 million instead of $1.5 million, your spouse might receive a larger inheritance. She can then do some heavy gifting to reduce her own taxable estate.
In fact, you might want to give away assets yourself during your lifetime. Some state laws are structured so that lifetime gifts are even more effective in cutting state estate taxes than cutting federal estate taxes. It even may be possible to make deathbed gifts, to reduce state estate tax, as long as you've executed a durable power of attorney to allow someone to make such gifts if you're not capable.
Planning to move? Check estate-tax rate
Here's a way to avoid all that complicated tax planning: If you're considering a move after retirement, move to a state that has no estate tax and that is unlikely to establish one in the future. California, Florida and Nevada, for example, have constitutional obstacles to passing a meaningful state estate tax.
If you relocate or move to a second house in another state, beware: Your old state may come after your estate and demand taxes. So you should do everything possible to help your executor prove that you truly were a resident of your new, low-estate-tax state.
For example, spend more than half the year living in your new state. Change your driver's license, auto registration, bank accounts, etc., to the new state. Register to vote in your new state, and start filing tax returns from your new address.
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