The 'death tax' is far from dead

The federal estate tax remains up in the air, but the states that traditionally piggybacked on the federal tax are rewriting their rules so they don't lose their cut.
By Liz Pulliam Weston

When it comes to death and taxes, most of the focus in 2006 centered on Congress' ongoing battles over the federal estate tax.
But many states impose their own taxes and costs when residents die. Estates too small to trigger the federal tax can easily rack up thousands of dollars in state death taxes and probate costs. Far from being repealed if the federal tax is rescinded, this state burden is on track to rise over time.
Some states have their own estate- or inheritance-tax systems that are independent of the federal estate tax system.
Another group of states is imposing new estate taxes to make up for revenue from the waning federal tax.
Finally, some states have expensive and lengthy probate systems that apply to an increasing number of estates.
The federal estate tax is scheduled to phase out over the next few years and disappear entirely in 2010 -- only to return in 2011 when the temporary repeal expires. Opponents of the estate tax are struggling to make repeal permanent; the House has already voted to permanently repeal it, but the bill never got to the floor of the Senate for a vote.
But many states have estate or inheritance taxes that are independent of the federal system. Those states, according to John Logan, senior tax analyst with CCH Inc., include: Connecticut, Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Ohio, Oklahoma, Pennsylvania and Tennessee. (Connecticut's tax is scheduled to disappear after 2006.)
State estate taxes, like the federal version, are assessed on the estate as a whole. But states can have different rules about who pays.
Breaking down the exemptions
Inheritance taxes target bequests to the beneficiaries, rather than the estate itself. Typically, beneficiaries are divided up by their relationship to the deceased, with the biggest tax breaks going to those with the closest ties. In Iowa, for example, bequests to spouses, children, parents and other direct descendents (grandchildren, great-grandchildren, etc.) or ascendants (grandparents, etc.) are exempt from the state's inheritance tax. Property destined for brothers, sisters and siblings-in-law is assessed at rates ranging from 5% to 10%, while the rate for other inheritors runs from 10% to 15%.
You can find details about state estate taxes at CCH's financial planning Web site.
In the past, most states haven't had to impose separate taxes to get a piece of their residents' estates. Instead, the states received a portion of what the estate owed the federal government. This "pickup" tax raised state coffers without the estates owing any extra. However, states are losing this boost. The federal law temporarily repealing the estate tax has already phased out the states' ability to take a portion of said tax. That cost states billions in lost revenue.
So it's probably not surprising that several states are trying to hang on to their piece of the pie by decoupling their estate tax system from the federal system. In effect, they're pretending that the repeal isn't happening and taking from their residents' estates some of what they used to get from the federal government.
The search for funds
Illinois was the most recent state to unhook from the federal law in hopes of recouping $45 million to help fill its $5 billion budget gap.
Some states made their decoupling temporary, hoping that revenues would improve enough in coming years so that they wouldn't miss the lost tax. The states also might get a break if efforts to make the federal repeal permanent fail. The full state death-tax credit would return, along with the rest of the federal estate tax system, in 2011.
Taxes aren't the only costs associated with death. Probate, the court process that follows death, usually costs some money and typically affects far more people than estate taxes.
Fortunately, probate is no big deal in most states. Creditors are identified and paid and the remaining assets are distributed to heirs, usually all within a few months. Fees typically range from a few hundred to a few thousand dollars.
Two states, though, are notorious for their lengthy and expensive probates: California and Florida.
The trigger
In California, probate is generally triggered when an estate is worth more than $100,000. That amount doesn't rise with inflation, so over time more and more estates are subject to probate.
The typical probate in California can take 12 to 18 months, and some go on for years. (Marilyn Monroe's estate took 18 years to settle.) The long waits for heirs aren't the only problem: The costs for probating even a modest estate can be astronomical.
Attorneys and executors can each take 4% of the first $100,000, then 3% of the next $100,000, then 2% of the next $800,000, then 1% of anything over that amount. So a $300,000 estate can rack up $20,000 in probate fees. (Monroe's probate fees totaled more than $1 million, says estate planning expert Denis Clifford. Her total debts were about $400,000, leaving just $100,000 to be divided by her heirs.)
By the way, those probate fees are based on the gross estate -- the value of all the property, not counting any mortgages, loans or other debt.
In Florida, estates worth more than $75,000 are subject to probate. For small estates, the process usually takes about six months. Closing a larger estate can take 15 months or longer. Fees for attorneys and executors of about 3% each are usually considered "reasonable" by state law.
There are some benefits to going through probate. The process is monitored by a judge, which theoretically should make it harder for a corrupt executor to defraud your heirs. You also don't have to do anything or spend any money in advance to prepare; rather, your estate will go through probate if you don't take steps to avoid it.
The avoidance technique
But if you have even a modest estate (a home, some investments, a bit of cash), estate-planning attorneys in states with high-cost probates usually recommend avoiding the process. If your estate is relatively small, you may be able to skip probate entirely with techniques like owning real estate in joint tenancy and designating beneficiaries for your financial accounts (known as creating "pay on death" accounts; talk to your financial institutions for details). If your estate is larger, a kind of revocable trust known as a living trust might be the answer. A review of Clifford's Nolo Press book, "Plan Your Estate," could help you decide.
Now, what do you do about state death taxes? If you're rich enough, finding another state to live in is always a possibility (Alaska, maybe, or Hawaii?). Otherwise, you might decide to use tax-minimizing techniques, such as bypass trusts, or change who gets what in order to reduce inheritance taxes. If you want to provide the money to pay taxes so they don't come out of your heirs' share, a life-insurance policy held in an irrevocable trust might be the way to go.
Unfortunately, estate planning is often no place for amateurs. As you can see, the rules are complex and ever-changing. It's tough for even the pros to keep up.
If you have enough money to be worried about death taxes, consider spending a little on an attorney who's an estate-planning specialist. Your local bar association can provide referrals. Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.