You’ve heard the idiom that the only two guarantees in life are death and taxes. When the two intersect, there can be hell to pay. Maybe not hell but certainly the IRS. On a federal level, most people are protected by the estate tax exemption ($5.43 million in 2015) and don’t owe any of these transfer taxes when they die.
However, the tax landscape is a bit different on the state level. Some states levy an estate tax, some collect inheritance tax in lieu of an estate tax and some do both. These state taxes don’t have quite the generous exemption that the federal tax has. That means even if you’ve accumulated a modest amount in assets, these assets could be subject to tax assessment. There are ways to avoid being penalized, but they require some foresight and planning as well as the advice and guidance of your tax professional.
‘Death Tax’ on a State Level
First, let’s identify the 15 states (plus D.C.) that have an estate tax: Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island Tennessee, Vermont and Washington. The six states that have an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania. Notice that Maryland and New Jersey have both. In total, that’s 19 states that have some type of death tax.
A number of the states are working toward increasing the exemptions – New York is leading the way here. But Kentucky, for example, enforces fairly stiff inheritance tax laws if you’re not leaving your legacy to an immediate family member. Immediate family members (rated Class A) are exempt from the inheritance tax, but suppose you don’t have children and you’d like to leave your assets to your niece or nephew. Or perhaps you adopted a child in infancy. In both of these situations, the heir would be considered a Class B. The Class B exemption is only $1,0001. If you choose to leave assets to a cousin or a close friend, that’s a Class C rating with an exemption of only $500.
Maryland, which increased its estate tax exemption this year to $1.5 million from $1 million, also has an inheritance tax. So in the aforementioned scenarios, non-immediate family members would owe 10%2 of what you leave them. D.C. and Massachusetts’ exemptions sit at $1 million and in New Jersey, only $675,000 is exempt. Now, it’s safe to assume that these state taxes affect far more people than the federal tax. It’s not unlikely that you’d accumulate $675K or even $1 million in assets over your lifetime.
Knowing this, there are a few ways you can avoid these taxes. Bestowing a gift is one way to circumvent tax obligations. You can give $14,000 tax-free each year to whomever you wish. That may not seem like much if your goal is to give more money to one person. But you and your spouse have separate tax limits and may both give that amount to the same person each year. Let’s say it’s your niece. Then, you both could give that same amount as a gift to her husband without it triggering a tax. Suddenly instead of $14,000, you were able to give them $56,000. That’s no small amount.
You can also decide to help out with certain qualified expenses, like tuition, or non-reimbursed medical and dental expenses. This money is exempt from the gift tax limitations, so even if you gifted $14,000, you could still contribute to these financial obligations. In these situations, make sure to pay the doctor, dentist or school directly or the exemption won’t apply. You’ll also want to make sure that the student you’re helping doesn’t have financial aid because then your help could interfere with his or her eligibility.
If education is what you’re most interested in helping with, you may want to set up a 529 college savings plan. That way the money could go toward more than just tuition, instead helping with books, supplies and housing. The money taken out is tax-free and most states will let you deduct the contribution from a state income tax return. While these plans aren’t exempt from the gift tax limit, you can make five years of contributions at once. Consult your tax advisor before settling on a direction.
Tax advantages are great, but distributing part of your legacy while you’re alive is also a lot more rewarding because you get to see how your money is helping your loved ones in real time. There’s not a more satisfying feeling than knowing your hard-earned and hard-saved assets bettered the lives of those you care about.
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