States Keep a Cut

How you and your heirs can avoid paying too much.

By Ronaleen Roha

From Kiplinger's Personal Finance magazine, November 2005

Even as Congress considers whether to end the federal estate tax for good, the Òdeath taxÓ is alive and well in many states. In fact, where you live can have a major impact on how much your estate will have to pay in taxes when you die.

Congress decided in 2001 to phase out the federal estate tax; this year, only estates that exceed $1.5 million are subject to the tax, and the size of estates protected from it will gradually increase over the next few years, reaching $3.5 million in 2009. (The tax is due to disappear entirely in 2010, then be reinstated in 2011 on estates worth more than $1 million.)

What has states seeing red -- in the form of potentially lost revenues in the billions of dollars -- is a provision of the 2001 law that phased out the state death-tax credit. In the past, the feds allowed a dollar-for-dollar credit on the federal estate-tax return for death taxes paid to a state. As a result, a state could get an infusion of cash from any estate large enough to owe federal tax. On a $3-million taxable estate, for example, the credit amounted to $182,000. On a $10-million taxable estate, it was more than $1 million.

That windfall was too good to pass up, especially because it didn't cost the estates of state taxpayers anything extra. States simply siphoned off a bit of the money that would have gone to the feds. All 50 states and the District of Columbia enacted so-called pickup or sponge taxes, conveniently set at the amount of the federal tax credit.

This year marks the end of the four-year phaseout of the death-tax credit, so for the first time states won't get a dime -- unless they separate their own tax from the federal levy. And that's just what's happened in 18 states -- Connecticut, Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Ohio, Oregon, Rhode Island, Vermont, Virginia, Washington and Wisconsin -- plus the District of Columbia.

Basically, 15 states and Washington, D.C., "decoupled" their tax from the federal levy, which means they can continue to collect state death taxes as if the federal phaseout of the tax credit had never happened. Three states, Connecticut, Nebraska and Washington, have passed separate, new estate taxes.

Ease the pain. What this means is that instead of splitting the amount that would have gone to the federal government, states will actually nick your estate in addition to any federal tax that might be due. In fact, some estates that don't owe any federal tax will end up paying the state. That makes planning to avoid state taxes more important than ever. (A deduction for state death taxes replaced the federal credit, but deductions aren't as valuable as credits.)

Although states hope to recoup those lost billions, there are ways to ease the bite or avoid it entirely. The following strategies are complex, so consult an estate-planning specialist.

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