Planning Techniques For The Other Tax
Due to uncertainty arising from the one-year federal estate tax phase-out in 2010, some clients are reluctant to implement an estate plan. They may assume that, without the estate tax, everything will simply pass to the next generation free from any taxes. This is not the case.
During the next 20 to 30 years, $9 trillion will pass from one generation to the next; Uncle Sam and the states will want a piece of that transfer. By recommending a simple wealth transfer plan such as a smart trust, a gifting program or a way to leverage deferred annuities, you can make sure your clients money goes to the right peopletheir heirs.
The Other Tax: State Inheritance Tax
No sooner than the ink was dry on the Economic Growth Tax Relief and Reconciliation Act of 2001 did states begin to decouple from the federal system and implement their own estate tax structure. Pre-EGTRRA, the federal tax code gave taxpayers a credit for federal estate taxes paid to the state governments on the federal tax return.
This allowed the states to pick up any taxes that were left. This is known as the sponge tax or pick-up tax. In the past, most states were satisfied with the sponge tax.
However, under EGTRRA the state death tax credit and the sponge tax are disappearing from 2005-2010. As a result, many state legislatures have passed measures to capture the tax revenue they are losing or have maintained a separate tax system. So far, 24 states have decoupled and more are expected. (See Chart 1.)
What Will the Tax Be?
The type and amount of the state death tax varies from state to state, thus making planning difficult. For example, if a person owns property in one state and lives in another state, then both states will be allowed to impose a tax on the value of the property and the size of the estate. So, without proper planning, a client may be faced with both a federal estate tax and two state taxes.
Lets look at an example.
Charlotte and William Eagan, ages 70 and 72, respectively, have an estate worth $5 million, growing at 5% after-tax. As Pennsylvania residents, they have been following the tax legislation and are reluctant to implement an estate plan. The estate, which the Eagans want to leave entirely to their children, consists of real estate, a deferred annuity and cash.
As Chart 2 illustrates, without planning, the Eagans only can pass 55% of the estate to their children. And even if the federal estate tax is repealed, the Eagans will still pay over $1 million in state taxes.
Wealth Transfer Planning Strategies
The Eagans can transfer more to their children by implementing simple planning techniques. These include setting up a simple gifting program, a smart trust, or using their deferred annuity to fund the program.