How Tax and Non-Tax Considerations Impact Estate Planning- Part I

When most folks think about Estate Planning, they focus on who gets what along with who distributes what. In cases in which an individual’s estate is not expected to exceed the Applicable Exclusion Amount, currently $12.92 million, taxes may simply be an afterthought. Comprehensive Estate Planning, though, encompasses much more than the foregoing. This is the first part in a two-part series that explores the various considerations, both tax and non-tax, for Estate Planning. When focusing on the tax aspects of Estate Planning, one considers the income, gift, and estate tax at both the federal and state level. At the federal level, we have a unified estate and gift tax system applicable to everyone. At the state level, taxes vary widely. Some states may impose estate, gift, inheritance, or income taxes. States diverge in the type of property they recognize and their property and sales tax rates as well, all of which should impact the planning undertaken.

If you live in a state that imposes an income tax, it’s important to understand what types of income your state taxes. Individuals at or nearing retirement prefer states that exclude Social Security benefits from taxation and that provide exemptions for other common forms of retirement income, such as private pensions or Individual Retirement Accounts (“IRAs”). These states generally have lower property and sales taxes that allow their residents to make the most of every dollar, which has become increasingly important as interest rates and food costs continue to rise.

Eight states, including Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not impose a state income tax. This protects a resident’s income from diminishment because of state income tax liabilities. Of those eight states, Florida, Nevada, Tennessee, and Wyoming impose neither an estate tax nor an inheritance tax. Nevada provides another advantage with a median property tax rate of just over $572 per $100,000 of home value. Unfortunately, Nevada has a combined state and local sales tax rate of 8.23%. Wyoming provides both a low combined state and local sales tax rate (5.22%) and a median property tax rate of $605 per $100,000 of home value.

Arizona, Alabama, Colorado, and South Carolina impose a state income tax, but none impose an estate or inheritance tax. Arizona, Alabama, and South Carolina all exempt Social Security benefits from state income taxes. Colorado exempts Social Security benefits from taxation at the state level if the retiree has attained the age of 65. South Carolina allows taxpayers aged 65 and over to exclude up to $10,000 of retirement income versus $3,000 for those under the age of 65. South Carolina also allows seniors to deduct $15,000 of other taxable income as well. Colorado’s combined state and local sales tax rate comes in at 7.77% and its median property tax rate is $505 per $100,000 of home value. South Carolina bests Colorado slightly with a combined state and local sales tax rate of 7.44% but has a slightly higher median property tax rate of $566 per $100,000 of home value. Alabama taxes IRA and 401(k) distributions but offsets that with a lower median property tax rate than nearly any other state in the nation at $406 per $100,000 of home value. Its average combined state and local sales tax rate is a bit high at 9.24%, but it allows anyone over the age of 65 to exempt the state portion of property taxes and allows lower-income residents an exemption from all property taxes on their principal residence.

Most states impose a tax on capital gains ranging between 2.9% in North Dakota to 13.3% in California. Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, and Wyoming do not tax capital gains. Of the states on the list that do not impose a tax on capital gains, New Hampshire stands alone in imposing a state income tax. Although it does not impose a state income tax, Washington recently passed legislation imposing a tax on capital gains at a rate of 7%. The legislation included a $250,000 standard deduction.

In addition to considering the potential estate, gift, inheritance, income, sales, and property taxes imposed by a state, individuals need to consider the types of ownership acknowledged in their state. For example, Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin all have community property. In addition, Alaska, Florida, Kentucky, South Dakota, and Tennessee allow their residents to elect into community property status for property held in a community property trust. In general terms, community property states consider the fruits of the labor of either spouse to belong to the community of their marriage, requiring equal access to the assets by both spouses. Community property provides a significant tax advantage by allowing a step-up in basis for all of the community property at the death of the first spouse, rather than just the decedent spouse’s assets, as would be the case in separate property or common law states. Community property states impose no restrictions on the distribution of the decedent spouse’s share of the community property, unlike separate property states.

While common law states do not permit residents to create community property, they provide other protections to a surviving spouse not found in community property states in the form of elective share rights. Typically, the surviving spouse may elect against the will of the predeceasing spouse to receive an intestate share of the estate. This amount depends upon many factors but often ends up around 1/3 of the “estate.” In some common law states, the spouse may elect against an augmented estate, which includes non-probate assets such as those found in a revocable trust. In other states, the survivor may only elect against the probate estate.

About one-half of the separate property states recognize “tenancy-by-the-entirety” or “TBE.” TBE requires unity of the interests of time, title, interest, possession, and marriage. Illinois, Indiana, Kentucky, Michigan, New York, North Carolina, and Oregon recognize TBE ownership for only real property. Alaska, Arkansas, Delaware, Florida, Hawaii, Maryland, Massachusetts, Mississippi, Missouri, New Jersey, Oklahoma, Pennsylvania, Rhode Island, Tennessee, Vermont, Virginia, and Wyoming all extend it to personal property as well. TBE property requires both spouses to encumber or sell the property and provides certain creditor protection if the creditor is only a creditor of one spouse. Understanding the protections and limitations of TBE ownership helps shape an estate plan in the separate property states that recognize that type of ownership.

As this article makes clear, Estate Planning involves more than just who gets what when and who gives it to whom. It requires consideration of taxes applicable to an individual during life and to that individual’s estate at death. It also requires understanding the nature and character of assets in that individual’s estate as well as state law governing the title and disposition of assets.