The American Taxpayer Relief Act of 2012 has eliminated the estate tax for the majority of Americans. Well, it eliminated the federal estate tax. For those of us who live in Jersey, the estate tax is very much alive. Not to mention that we live in one of only two states (Maryland is the other) that levies both an estate tax and an inheritance tax.
There are currently only 14 states (plus the District of Columbia) that still have an estate tax, and every single one of them has a higher threshold than Jersey’s $675,000. That low threshold means that many New Jerseyans will be subject to the estate tax, absent legislation to change it.
The marginal tax rate starts at 4.8% and gradually increases to a maximum of 16% on taxable estates over $10,040,000. That translates to a tax of $33,200 on $1,000,000 estates, $99,600 on $2,000,000, $182,000 on $3,000,000 and $391,600 on $5,000,000. Certainly not insignificant.
There is, however, an unlimited marital deduction, meaning that there is no tax on property left to a surviving spouse. The tax kicks in when the surviving spouse dies.
So, what to do? One solution is to move to a state that doesn’t impose an estate tax. That’s not a particularly good solution for those with family in New Jersey. Also, there is nothing to prevent the state you move to from introducing (or re-introducing, as Illinois recently did) an estate tax in the future.
Since the face amount of life insurance is includable in your estate, a very effective solution is to gift your life insurance to an irrevocable life insurance trust (ILIT). As previously mentioned, the tax on a $1,000,000 estate is $33,200. If a $250,000 life insurance policy is part of the estate, removing it will save $12,800, as the estate tax on $750,000 is $20,400.
There are tradeoffs to this approach, as the policy values become unavailable to the original owner of the policy. Thus it is usually only appropriate for individuals over 60, absent extenuating circumstances or very large estates. Additionally, the insured must live three years after the date of gift to avoid the policy being brought back into the estate.
Another technique is to buy an amount of life insurance equal to the estimated estate tax (and put it in an ILIT, of course). The negative to this is the premium. There are some who say the kids will just have to make do with the remainder, after the estate taxes are paid, and there are others who choose the life insurance approach.
Of course buying life insurance to fund the estate tax burden doesn’t lessen the tax at all, it just creates the money to pay the bill. The state will collect the same amount either way.
Absent very large estates, planning for this can wait until after the children are educated and retirement is near. It is a complex area that requires the expertise of CPAs and attorneys who specialize in this area. When done properly, it can mean six and even seven figures going to heirs instead of (or in addition to) the state.