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How much of our nest egg will be lost to estate taxes when we pass?

Is there anything we can do?

Would moving to another state help?

We hear these questions frequently from clients. They’ve often heard stories of six or seven figure estate tax bills and are worried their hard earned wealth will be lost to the IRS instead of going to loved ones and causes they care about. Washingtonians face an additional burden because Washington adds a 10-20% state estate tax on top of federal estate taxes.

WA state estate tax explained

Before discussing what can be done, here are a few things to know about the state estate tax for Washington residents:

  • It’s a tax on your accumulated wealth assessed by WA state when you die.
  • The tax rate starts at a 10% for the first taxable $1 million and climbs to 20% at $9 million.
  • Your first $2.193 million (in 2020) passes tax free – called an “exemption”. However, if your estate is $6 million, your WA state estate tax could be around $550,000.
  • If married, assets pass by default to your surviving spouse are not subject to estate tax regardless of value.
  • This exemption is not “portable” from one spouse to another. If a married couple has a $6 million estate and Spouse 1 dies, everything passes tax free to Spouse 2 by default. But, when Spouse 2 dies, he or she will only get one $2.193 million exemption at death – Spouse 1’s exemption is lost.

Many are likely to cross that threshold with a house, retirement savings and life insurance benefits alone. Add rental properties or a successful business and you could be looking at a significant tax bill. Don’t forget that many of those retirement plans have been deferring taxes all these years, so in addition to estate taxes, your beneficiaries will owe income tax on the entire amounts, effectively creating a double taxation of these assets.

So, should you move out of Washington state? This might solve the Washington estate tax issue, as Washington presently has no claw back provisions to make you pay the estate tax after you move. But you’ll still face federal estate taxes if your estate value exceeds the federal $11.58 million exemption. Many practitioners also expect the federal exemption to drop dramatically in the coming years due to the COVID-19.

But what if you have your life, business, and family here? And, what if your life here is a higher priority than planning for estate taxes? What else can we do? Before you put up that “For Sale” sign, here are a few options to consider.

Strategies to stay in WA state

Let’s consider some options that allow you to stay in WA state. Remember that these should be carefully considered with your estate and financial planning team, as they know your specific situation. Here are a few options, from the 101 level to the more advanced.

  • Do nothing. It may sound surprising coming from a financial planner, but it is an option. Before going down this path, it is important to note that if you avoid any planning, there is still a plan written for you by the laws of the state and federal government, as discussed in Plan by Default or Plan by Design.
  • 101 – Preserve that exemption! If you are married, a Washington Credit Shelter Trust effectively creates “portability” of your exemptions. Most wills in Washington State have this provision included in it. This trust is created by your will to receive assets when the first spouse dies, typically to preserve the $2.193 million exemption that would be lost by passing everything directly to the surviving spouse. The spouse is typically the trustee of this trust and may receive income from for life. Then, upon passing, the proceeds go to their beneficiaries free of Washington estate taxes.
  • 201 – Give it away along the way. Washington state has no gift tax or limit on lifetime gifting, as of 2020, so gifts while you’re alive can reduce estate taxes after you pass. In addition to the $15,000 annual gift allowance, an individual may give away $11.58 million over their lifetime free of any gift tax (see Can You Gift Too Much?). If gifting to an irrevocable trust using the right strategies, you have the potential to grow these gifts income tax free and transfer them to the next generation estate tax free.
  • 301a – Want to reduce taxes, but still need income? You won’t want to completely give your assets away. This is where a sale to an Intentionally Defective Irrevocable Trust (IDIT) can help. You can sell an asset to the trust in exchange for a promissory note, which is a tax free transaction due to special provisions in the trust. In return, you’ll receive payments on this loan from the trust. You’ll pay income tax on trust earnings along the way, but the value, including future growth, is now outside of your estate is not subject to taxes when passing to your beneficiaries.
  • 301b – Still need more potential access to the funds? A Beneficiary Intentionally Defective Trust (BDIT) is a variation that keeps you, the seller, as a beneficiary of the trust, allowing access to funds for health, maintenance, and support. These can be effective for a business or other highly appreciating asset.
  • 401 – Want your trust to last for generations? Let’s visit South Dakota. You can live in Washington and establish a trust in South Dakota. Why do that? Because a trust is governed by state law where it is domiciled. South Dakota has some of the most appealing and flexible trust laws in the nation, alongside Delaware, Nevada, Tennessee, New Hampshire. Assets placed in trust in South Dakota have the benefit of no state income taxes, no generation skipping taxes, and an unlimited duration, meaning they can exist for generations, whereas Washington trusts have a 150 year limit. For large estates, this can reduce estate and gift taxes, and preserve wealth for loved ones and causes you care about.

Often, our biggest impact for clients comes from joining forces with CPAs and attorneys to help clients navigate the tax laws and optimize strategies, specifically in estate and tax planning. While estate taxes can be a burden, there are many strategic opportunities at your fingertips! With an $11.58 million federal estate tax exemption (set to go back to $5 million in 2025 or sooner if revised legislation is passed) and historically low interest rates, many of the tools used for tax sheltering strategies are more effective today than ever before. Whether you live in Washington or not, there are significant opportunities for families to use these strategies and create a lasting impact on their future…without having to pick up and move.

Sources – PDR CPAs, Wealth Advisor Trust, Washington DOR

The “Alterra” name was coined by joining the Latin roots “alter”, the origin of the word “altruism” with “terra” meaning earth or land. This name reflects the company philosophy of “clients before profits” and providing firmly grounded advice.