Death Taxes Are Coming—And Not Just for the Fantastically Wealthy
“Death taxes.” Even the word sounds foreboding. There are many different types of taxes that happen after a death, but the most common type of tax that fits this understanding is what’s known as the estate tax. If you’re a Washington resident, you have two: a federal estate tax, administered by the Internal Revenue Service (IRS); and our state estate tax, administered by the Washington Department of Revenue (DOR). The rules and limits for these two estate tax systems are very different, and as a result can cause tremendous confusion among both Washington residents and estate planners alike.
The Federal estate tax is a flat tax of 40% on a deceased person’s net worth over $12,060,000 in 2022. In this case, it includes not just assets owned by an estate, but many other types of assets as well, including living trust assets or assets which have designated beneficiaries. This $12.06m figure is called the federal exemption and any amounts under this pass free of federal estate tax. The Washington estate tax is a variable 10-20% rate on any net worth over $2,193,000 in 2022. Importantly, spouses can share both exemptions in the federal system by leaving assets to one another at death without more planning. In the Washington system, however, most spouses end up sharing a single exemption.
It’s true that the federal estate tax has rapidly increased from $1,000,000 in 2002 to $12,060,000 in 2022, and as a result fewer estates are paying estate taxes than at any point in last century. At the same time though, Washington families find little relief in a generous federal system when their state imposes a state estate tax on $2,193,000 of value. At a time of rapidly increasing cost of living and soaring home prices, more Washingtonians than ever are faced with paying the estate tax at their death—all while hearing, wrongly, that death taxes only impact the exceedingly wealthy.
Perhaps most surprising of all is another tax lurking in plain sight—income taxes. Washington has no state income tax, and so this isn’t a problem unique to Washington, but rather one most middle-class Americans are dealing with (whether they know it or not). At death, capital appreciation is generally erased and the basis of the asset in the hands of its beneficiary is the fair market value as of the decedent’s date of death. This “step-up in basis” is unlimited and it provides relief and uniformity for heirs who inherit assets which may have been acquired decades in the past.
The step-up, however, has long been denied for a particular category of assets called “income in respect of a decedent.” This includes, among other things, a person’s traditional qualified retirement accounts of all types: IRAs, 401(k)s, 403(b)s, etc. The single largest investment asset of the traditional middle-class family (excluding their primary residence) is their qualified retirement account—one of the only assets curiously denied the benefit of the step-up in basis. If a person uses a traditional qualified retirement account, he or she will likely be passing an income tax liability onto his or her heirs, a liability that doesn’t exist for nearly any other type of asset.
It gets worse, though. At the end of 2019, a bipartisan congress undertook the brave endeavor of addressing inequity in inheritance for the first time since 1986.[1] Among the provisions of what is now known as the SECURE Act was an escalation of the income tax liability at the death of the owner of a qualified retirement account. Not only would the heirs of the middle class be taxed on assets which represent middle class wealth; those taxes are now owing sooner, meaning they are usually payable at higher income tax rates. As a reminder, this has nothing to do with net worth. A traditional qualified retirement account could bear this burden no matter its size and no matter the net worth of its owner. Congress has now steeply escalated income taxes on the children of middle-class decedents, even if no estate tax is technically owing. That sounds like a “death tax” to this author.
Many people have heard that “death taxes” are a myth; that they only affect the fantastically wealthy, or that fears are overly exaggerated by politicians to scare middle class Americans about a tax that won’t ever impact them. The reality is obviously a bit more complicated. In today’s world, estate planning attorneys are counseling clients of many walks of life on managing tax liabilities after death. Although size and net worth of the estate will always play a role in the amount of tax efficiency desires, the realities of modern state and federal taxation mean that death tax planning is now for everyone.
If you are interested a learning more about incorporating death tax efficiency as part of your estate plan, the attorneys at Holmquist + Gardiner are ready to assist you. You may contact, pr@lawhg.net.
[1] Although the Senate votes were strongly bipartisan, every single member of the Senate who was running in the 2020 presidential election curiously abstained from the vote.
