Planning for State Estate Taxes and IRD Income Taxes at death
By Russell E. Towers, JD, CLU, ChFCMr. Towers is vice-president, business and estate planning, with Brokers’ Service marketing Group, Providence, RI. He can be reached at Russ Towers [email protected]
The Tax Relief Act of 2010 provides a temporary $5,000,000 federal estate tax exemption for individuals until 12/31/2012. Absent any intervening legislation by Congress, the law will “sunset” on 12/31/2012 and the federal estate tax exemption will fall back to only $1,000,000 with a maximum estate tax rate of 55%. This uncertainty has caused many individuals with estates under $5,000,000 to adopt a “wait and see” attitude when it comes to planning the transfer of estate assets to their heirs.
However, what is certain in many states in the Northeastern and Mid-Atlantic parts of the United States are State Death Taxes. What is also certain are “Income in Respect of Decedent” (IRD) income taxes levied on beneficiaries of qualified retirement assets like 401(k) plans and IRAs under IRC Section 691(a). The combined effect of both state death taxes and IRD income taxes can substantially shrink estates valued at less than $5,000,000. Insurance owned by an Irrevocable Life Insurance Trust (ILIT) for the benefit of the family of the estate owner can offset the shrinkage caused by the combined state death taxes and federal -state income taxes.
Generally, state death taxes range from about 5% to 16% of the taxable estate for states that follow the credit for state death tax table of IRC Section 2011. And post-death IRD income taxes on 401(k) and IRA beneficiaries can easily be taxed at a combined federal and state income tax rate ranging from 30-40%.
Summary of selected states that impose state death taxes and current corresponding state exemption amount
Massachusetts … $1,000,000 exemption and a max estate tax rate of 16%
Rhode Island … $892,865 exemption and a max estate tax rate of 16%
Maine … $1,000,000 exemption and a max estate tax rate of 16%
New York … $1,000,000 exemption and a max estate tax rate of 16%
Vermont … $2,750,000 exemption and a max estate tax rate of 16%
Connecticut … $2,000,000 exemption and a max estate tax rate of 12%
Maryland has both an estate tax and an inheritance tax. Max estate tax rate is 16% with a $1,000,000 exemption. The max inheritance tax rate is 10% with a $150 exemption, if applicable. Maryland state inheritance tax due, if any, is subtracted from the value of the taxable estate before calculating the Maryland estate tax. Generally, if property is left to children of the deceased, there is no MD inheritance tax due … only MD estate tax.
New Jersey has both an estate tax and an inheritance tax. Max estate tax rate is 16% with a $675,000 exemption. The max inheritance tax rate is 16% with no exemption, if applicable. New Jersey state inheritance tax due, if any, is subtracted from the value of the taxable estate before calculating the New Jersey estate tax. Generally, if property is left to children of the deceased, there is no NJ inheritance tax … only NJ estate tax
Pennsylvania has an inheritance tax with $0 exemption and rates ranging from 0% to 15% depending on the family status of the inheriting person. Generally, children over age 21 will be taxed at a 4.5% rate.
New Hampshire has no state estate tax or inheritance tax
Virginia has no state estate tax or inheritance tax
Hypothetical case study of a $3,500,000 estate which includes a $1,500,000 ira
Assume a 72 year old Massachusetts resident has a taxable estate of $3,500,000 of which $1,500,000 is in an IRA. Massachusetts has a $1,000,000 state exemption and the MA state estate tax is still calculated according to the IRC Section 2011”Credit for State Death Taxes” table. Assume an adult child is the beneficiary of the IRA and has a combined federal/state income tax rate of 35%. Here’s a breakdown of the combined state death tax on the Massachusetts taxable estate plus IRD income tax on IRA funds at death:
Federal Estate Tax in 2012 $ 0
MA state death tax in 2012 $229,200
IRD Income Taxes @ 35% $525,000
Total Taxes Post-Death $754,200
Note: In this example, there is no federal income tax deduction for federal estate taxes attributed to IRD values included in the gross estate because there are no federal estate taxes that were paid in the example above (IRC Section 691(c)). So, IRD income taxes will be paid at the full marginal income tax rate of the IRA beneficiary.
Solution: irrevocable life insurance trust (ilit) funded with required minimum distributions (rmd) from the ira to offset combined taxes and other costs
The estate owner could purchase a guaranteed no-lapse Universal Life (UL) or a guaranteed no-lapse Survivorship Universal Life (SUL) insurance policy with a death benefit of $1,000,000 owned by an Irrevocable Life Insurance Trust (ILIT). This tax-free death benefit would offset the combined Massachusetts state death taxes, IRD income taxes, and any other probate/administrative costs.
Part of the after-tax Required Minimum Distribution (RMD) from the IRA could be gifted each year as an annual premium to the Irrevocable Trust. The trustee of the Irrevocable Trust would be the legal owner and beneficiary of a Universal Life (UL) or Survivorship Universal Life (SUL) insurance policy so that the insurance death proceeds are not exposed to Massachusetts state death taxes. The $1,000,000 death benefit is also income tax free as death proceeds of life insurance under IRC Section 101(a). The current RMD on the $1,500,000 IRA for the 72 year old is $58,594 (Uniform Lifetime Table factor is 25.6 for age 72). The RMD each year will be determined by dividing the 12/31 value of the IRA each year by the appropriate Uniform Lifetime Table factor.