Estate Planning 101: What State and Federal Tax Laws Apply?
Estate planning isn’t something any of us can afford to put off. The future is entirely unpredictable. If something happened to you today, would your family have the resources to take care of themselves? Would all your assets pass to your loved ones the way you want them to? How much of your money would go to paying estate taxes instead of to your heirs? Would all your final wishes be respected? Estate planning advisors work with clients at all stages of life to develop strategies to put their minds at ease.
Minimizing estate taxes is a key goal of many of those strategies, so being familiar with relevant state and federal tax laws is important. The more you pay in estate taxes, the less is left for your loved ones to share when you’re gone. How much your estate will one day owe depends on those tax laws and how effectively you’ve planned ahead.
If you’re new to estate planning, there’s a lot of information to absorb. Your estate planning advisors will walk you through everything you need to know for your specific circumstances. In the meantime, here’s a look at some of the basics, including relevant tax laws.
Who Pays Estate Taxes?
A person’s estate may owe estate taxes after they die. The person who dies is called the decedent. Both federal and some state governments can impose estate taxes if the total fair market value of the decedent’s taxable property exceeds a certain amount.
Estate taxes have to be paid out of the decedent’s estate before assets are distributed to their heirs. The decedent’s personal representative/executor is responsible for remitting any taxes that are owed. With estate tax rates as high as 40 percent, estates that are taxed can lose a lot of their value before heirs get anything.
State and Federal Tax Laws about Estate Planning
Federal Law and Estate Tax Exclusions
The federal estate tax exclusion is high enough that the vast majority of American families will never pay federal estate taxes. Right now, these taxes are only relevant for the very wealthy—though many more families are going to be affected starting in 2026, when the exclusion may be reduced.
The IRS uses the basic exclusion amount (BEA) to determine an individual’s federal estate tax obligation. The BEA is increased each year to adjust for inflation. For 2023, the federal estate tax exclusion amount is $12.92 million per individual. Married couples may combine their individual exclusion amounts to shield joint assets. In other words, if wealthy spouses both die during 2023, their estates can avoid estate taxes on a total of $25.84M in assets.
Many more estates are expected to incur federal estate taxes in the near future. That’s because the federal exclusion amount more than doubled when the Tax Cuts and Jobs Act took effect in 2018 and is set to drop back down to its pre-TCJA level starting in 2026. It’s unknown exactly what the new BEA will be at that time. The number will be based on the 2017 exclusion of $5.49 million, adjusted for inflation through 2026, so likely somewhere in the low $6 million range per person.
State Laws and Estate Taxes
In addition to the federal government, 12 states and Washington D.C. also levy estate taxes on the estates of their residents. The states are Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington.
Each one’s estate tax laws are unique, but all the states use exclusion thresholds that are much lower than the federal exclusion amount. Massachusetts and Oregon have the lowest thresholds at just $1 million per individual. This means that many estates owe state taxes but not federal.
Residents in these places need to be extra diligent about estate planning to protect their assets. For example, take a retired Massachusetts resident who has modest assets and has owned a home in a Boston suburb for 30 years. The property is valued at $2M now, and they have $500k of other assets. If they die with the home in their own name and their total estate is worth $2.5M, there will likely be no Federal tax, but the estate will have to pay Massachusetts estate taxes of 6% to 8% (with a maximum state tax rate of 16 percent) on the entire amount.
The same resident could use estate tax planning strategies like trusts to remove the property from their taxable estate without necessarily having to leave or sell their home. The fair market value of their estate is just $500,000 when they die, so no estate taxes are owed. Their heirs could split up that money, plus inherit the property from the trust where their parent held it.
Gifting and Estate Taxes
Gifting may be part of your estate planning strategy for several tax-advantaged reasons. Giving away property and assets reduces the size of your taxable estate, so it can be done as part of MassHealth or Medicaid planning or as a strategy to lower or avoid estate taxes.
Gifting can also have tax consequences for the giver. Any gifts you make that exceed the IRS’s annual gift tax exclusion amount ($17,000 per recipient for 2023) are subject to the gift tax. The person who gives the gifts pays the tax, which ranges from 18 to 40 percent (using the federal estate tax rates). Even gifting to your kids and grandkids may affect the family’s estate tax picture in the future. Gift taxes can be avoided only in certain circumstances. Directly paying for someone’s tuition or medical costs isn’t considered a taxable gift, for example. Gifts to a spouse, political organization, or charitable organization may also be exempt from gift taxes.
Anyone who makes a lot of major, taxable gifts during their lifetime should be aware that the IRS and some states add those gifts back into the value of your estate when determining whether it owes estate taxes. Say someone gives away $3M to younger relatives during their lifetime and dies in 2023 with an estate valued at $10M. The $3M in taxable gifts is added in for a total taxable estate of $13M, exceeding the 2023 annual exclusion of $12.92M. This decedent’s lifetime gifts would trigger federal estate taxes.
This is just one example of the importance of discussing gifting strategy with advisors before writing any checks. Both state and federal tax laws can come into play, so estate tax planning has to be considered when making large gifts.
Need Specific Estate Planning Help?
If estate planning is on your mind, take a look at our recent Ebook that breaks down the main factors for consideration. Our advisors can have a conversation to help guide you on the right path in your estate planning journey. We’ll also help you navigate any state and federal tax laws that apply. Contact us today.
Stephen P. Ahern, CPA/PFS, CFP®, AEP®, MST provides individual financial, investment, estate and tax planning and small business consulting to a diverse base of clients including key top-level executives, high-net-worth individuals, business owners, venture capitalists, and entrepreneurs. Stephen co-founded and served as President of Wealth Management Advisors, LLC for twenty-one years before joining the Sachetta team.