Reflections on the tax law changes: state estate taxes more important.

February 14, 2013, by

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Our CPA friend Lars is on one of his crunchy early Sunday walks on the rocky beach. It's light by 7 now. Kyra is sleeping in. Lars can't, or at least would rather walk and think.

CPAs do more income tax work than estate work, but as he and his clients have matured and become more wealthy, he's taken a special interest in gift and estate taxes, and other aspects of estate planning. This morning he's trying to psych out the meaning of the recent Federal tax law changes for him and his practice.

One thing that has happened, at least in Lars's State of Washington, is that state estate taxes have become more important. The main reason is pretty obvious: the State exemption (in Washington) is $2 million per estate; the Federal is now $5,250,000. For a married couple those numbers are doubled, if there is proper planning. At these levels, Lars's rich Uncle Nils still has to worry about the Federal estate tax, but he's in a small minority. Lars and many of his clients fall between $4 million and $10 million, where only the State estate tax is a concern.

A Federal tax on Lars's estate is made even more unlikely by the escalator built into the exemption. It adjusts for inflation (the State exemption doesn't). That's how it got from $5,000,000 to $5,250,000 in the last couple of years. If it increases by just 3% a year it'll be over $7 million per estate, or $14 million for Lars and Kyra, in ten years. That assumes no law change, of course, but Congress hasn't shown much interest in going backwards with the exemption amount over the years.

Freedom from the Federal estate tax is further enhanced by portability, the law that gives to a surviving spouse whatever exemption wasn't used by the first to die. The State exemption doesn't have this. So if Lars dies with say $2,750,000 this year, Kyra will inherit the $2,500,000 of Federal exemption he can't use. She'll goof this up if she remarries, though, as Lars considers likely. She's a good spouse.

The greater likelihood of incurring State estate tax is mitigated a bit by its having a lower rate than the Federal. It's a progressive rate of 10-19% as opposed to the Federal bite of 40%. So if Lars and Kyra were both to die this year having $5.5 million, they'd be $1.5 million over their combined State exemption, and incur about $150,000 in tax for their heirs. Lars realizes that this is a relatively small chunk of the estate overall. But Lars and most of his clients want to avoid as much tax as possible, even at the State rates.