The estate tax is a tax on property transferred at your death, and it has generated a lot of controversy over the years. In recent years, changes in the tax laws have increased the amount that you're allowed to pass on to your heirs before you owe a piece to the IRS. For those who die in 2016, the $5.45 million exemption is high enough to keep the vast majority of Americans -- more than 99% of us -- from having to consider federal estate taxes.
However, 14 states and the District of Columbia have estate taxes of their own, and their provisions often impose taxes on much smaller estates.
How the estate tax laws changed for states
Until the early 2000s, most states took advantage of federal provisions that provided for a credit against the federal estate tax for any liability owed to states under state estate tax laws. Referred to as "pick-up taxes," the state provisions were tailored to take whatever federal law would allow them to without increasing a deceased person's total estate tax bill. From the states' point of view, estates would owe the same amount of tax, so it made sense to divert some of what would have gone to the U.S. Treasury into their own coffers.
However, the repeal of that credit for state estate taxes -- it was eliminated in 2004 -- led to different responses from the states. For some, the end of the exemption automatically eliminated the state estate tax as well, because they were tied together under state law. Other states took specific actions to repeal their own estate taxes. But some states chose to decouple from federal estate tax law, and keep or impose estate taxes on their own terms.
Which states have estate taxes?
You can divide the jurisdictions that still tax estates into two categories. One category includes the District of Columbia and nine states -- Delaware, Illinois, Maryland, Massachusetts, Minnesota, New Jersey, New York, Rhode Island, and Vermont -- that have structures that are very similar to what the pick-up tax used to look like. The others -- Connecticut, Hawaii, Maine, Oregon, and Washington -- have their own distinctive estate tax structures that don't necessarily resemble the old federal pick-up tax system.
The main challenge for residents in these states is that the maximum size of an estate that you can pass to heirs without owing state estate tax doesn't have to match the federal exemption. Hawaii and Maine currently match the federal $5.45 million exemption amount, and Maryland, New York, and Washington, D.C. have provisions in place that are gradually raising their respective exemption amounts toward the federal amount. However, others have much lower exemptions. For instance, New Jersey only provides an estate tax exemption on up to $675,000. Oregon and Massachusetts have $1 million exemptions, and Rhode Island's $1.5 million and Minnesota's $1.6 million amounts are much lower than the federal exemption as well.
In addition, the tax rates that states impose are often quite substantial. Those states that are tied to the old federal pick-up system typically charge graduated rates starting at 0.8% but climbing all the way up to 16%. Washington State has an even higher top rate of 20%, and Oregon and Hawaii match the old system's 16% maximum. Only Connecticut and Maine have lower top rates of 12%.
How to deal with state estate taxes
Bear in mind, however, that many states offer deductions against estate taxes that in some cases can prevent an estate from having to pay tax. For instance, the same marital deduction that allows you to pass assets to your spouse estate tax-free at your death typically applies in state estate tax situations as well. Prudent planning using a variety of estate planning techniques can help you reduce or eliminate potential state estate tax liability.
The key is to know whether you're at risk of having to pay estate taxes at the state level because of where you live. In addition, decisions about where you want to spend your retirement should consider state estate tax provisions in the places you're considering.
Estate taxes at the federal level mostly affect those who are extremely wealthy. However, because state estate taxes in some locations apply to much smaller amounts of wealth, you should pay close attention to make sure that you won't end up saddling your loved ones with a big tax bill to your state tax agency after your death.