In this edition of our monthly written communication, we address economics and markets only briefly.
We instead have devoted most of this edition to a discussion of the state of Washington estate tax. While most PIM clients may never pay federal estate tax, given the very high exclusion amount, we estimate that most could be subject to state-level estate tax in the absence of proper planning. If you do not live in the state of Washington and live in a state that does have an estate tax, then while the numbers in the examples below will not apply, then principles are the same. We hope you find the discussion informative and useful.
Economics & Markets
The initial optimism that prevailed in capital markets in January has given way to the reality that inflation is not retreating as quickly as hoped. Prices in some areas, such as goods, are clearly softening. Other areas, such as services, are accelerating according to the most recent data. The labor market report for January was significantly stronger than even the most optimistic forecasts (517k actual vs 189k median estimate according to Bloomberg). This dynamic suggests that elevated inflation levels may remain with us for longer than the market anticipated. Accordingly, hopes for interest rate cuts from the Federal Reserve this year have been dashed, putting mild pressure on both the equity and bond markets over the final two weeks of February.
As we described in January, current economic data looks relatively healthy, but forward-looking measures point to trouble. Until this changes, and the scales tilt one way or the other, we can expect a range bound market. It may not feel like it, but that is exactly what we’ve been through since the middle of last year. At the end of February, the S&P 500 was around the same level as in mid-May of 2022. The aggregate bond index is unchanged since late June 2022, on a total return basis. A lot of market drama, all the ups and downs, has resulted in little change to index values. Fortunately, with bond yields now in the mid-single digits, we are being paid to wait while the bulls and bears battle for control.
The Washington State Estate Tax
The primary purpose of this article is to discuss the Washington state estate tax. But it is helpful to first quickly review the basic elements of the federal law so that we may draw appropriate contrasts.
Federal Estate Tax
The federal estate and lifetime gift tax exemption amount for 2023 is $12.92 million, per person, portable between spouses. Portable means that any portion of the amount not used by the first spouse to die is added to the exemption amount of the surviving spouse.
For 2023, you may gift up to $17,000 to any number of persons you wish, without having to file a gift tax return. Gifts larger than $17,000 do require the filing of IRS Form 709 with your tax return. The reason for this reporting requirement is that, at your death, the IRS will add back the amount of gifts reported via Form 709 to determine if your estate is subject to tax. Another way to phrase this is that the value of your estate at death is the value of assets you owned plus the value of gifts you made over the years that were reported on Form 709.
State of Washington
The Washington state estate tax exemption amount for 2023 is $2,193,000, per person, NOT portable between spouses. Therefore, if the full exemption allocated to the first to die is not fully utilized, the unused balance does not transfer to the surviving spouse.
The Washington state estate tax schedule is:
$0 to $1,000,000
10% of the taxable amount
$1,000,000 to $2,000,000
$100,000 + 14% of the amount over $1,000,000
$2,000,000 to $3,000,000
$240,000 + 15% of the amount over $2,000,000
$3,000,000 to $4,000,000
$390,000 + 16% of the amount over $3,000,000
$4,000,000 to $6,000,000
$550,000 + 18% of the amount over $4,000,000
$6,000,000 to $7,00,000
$910,000 + 19% of the amount over $6,000,000
$7,000,000 to $9,000,000
$1,100,000 + 19.5% of the amount over $7,000,000
$9,000,000 and up
$1,490,000 + 20% of the amount over $9,000,000
We emphasize the lack of portability of the Washington state estate tax exemption amount for a reason. Upon the death of the first spouse, all assets may be passed to the surviving spouse tax free via the unlimited marital deduction. However, if this occurs without capturing the full exemption amount of the first to die, then the surviving spouse may end up with a sizeable estate upon her/his passing that could be subject to Washington state estate tax. An example may be helpful.
A married couple owns a home worth $2,000,000 (not uncommon in this part of the world). Each spouse has a retirement account worth $2,500,000. They have a joint investment account worth $500,000. Their total estate is valued at $7,500,000, not including the value of other personal property. It is likely the case that the primary beneficiary on their respective retirement plans is each other. It is likely the case that their home is jointly titled, like their investment account.
The first spouse dies. The surviving spouse inherits the decedent’s retirement account and becomes full owner of the residence and the investment account. Unless there is specific planning to the contrary, this is what would normally happen. And this scenario fails to claim any of the estate tax exemption amount of the first to die.
The surviving spouse now has an estate worth $7.5MM and presumably growing. Upon the death of the surviving spouse, the estate would be subject to estate tax on $5,307,000 ($7,500,000-$2,193,000). A taxable estate of $5,307,000 would pay $785,260 to the state of Washington in estate tax, using the table above.
If this is an undesirable outcome, then planning is required. Very generally, one of two estate planning approaches would be used in this example. 1) Trust planning to capture the Washington estate tax exemption of the first to die, 2) Gifting by the surviving spouse to lower the value of the estate. A quick word about each.
Trust planning may involve the establishment of a trust at the death of the first spouse, to be funded with estate assets up to the estate tax exemption amount. The trustee and beneficiary of this trust would be the surviving spouse. The appropriateness of this approach depends, in-part, on the types of assets available to fund the trust (some assets are better than others for this purpose).
In the absence of planning for the purpose of utilizing the estate tax exclusion amount of the first to die, and assuming that the surviving spouse is not keen on paying hundreds of thousands of dollars to the state at their death, then gifting to reduce the size of the estate may be appropriate. Indeed, lifetime gifting is often an estate planning strategy for reducing the size of an estate before, and after, the passing of the first spouse. One advantage to gifting to reduce the size of an estate is that the state of Washington does not add back gifts to determine the taxability of an estate, like the federal government does (as described above, IRS Form 709).
“But our estate is not valued at $7.5MM.”, you might say. Understood. If you are reading this document, then you are most likely a PIM client, which means you most likely have sufficient assets, or eventually will have, to qualify to pay some amount of estate tax to the state of Washington.
Consider the following scenario. A married couple owns a home with a current value of $1MM and retirement accounts with a total value of $2MM. No significant investments outside of retirement plans, and modest cash savings in the bank. The first spouse dies, and this $3MM estate transfers to the surviving spouse without capturing any of the estate tax exemption of the first to die. Three years later, the surviving spouse dies. Let’s assume modest growth of retirement account assets to $2.1MM and modest growth in the value of the primary residence to $1.05MM. Total estate value = $3,150,000. The estate tax exemption for the second to die is $2,193,000, leaving a taxable estate of $957,000 and tax due of $95,700. If paying this amount to the state is undesirable, then estate planning for tax avoidance is absolutely appropriate.
Conclusions and BIG DISCLAIMER
There are many reasons to have a comprehensive estate plan. Mitigating estate tax is just one of these. The information and examples above are simply to illustrate what may happen in these fictitious scenarios where no planning has been done. The “each situation is unique” phraseology feels overused at times. But in this case, it’s true. Each family/ estate planning situation is unique. The only way to address your specific set of circumstances is to engage in a planning process with an estate planning attorney. If you do not have an estate planning attorney and wish to receive a referral, please contact your PIM Financial Advisor.
PIM does not employ qualified tax professionals. PIM is not a law firm and does not employ attorneys. Therefore, in keeping with our fiduciary duty to our clients, we do not give tax or legal advice. Nothing in this communication is intended to be tax or legal advice. Rather, this is a recommendation to seek qualified tax and legal counsel. Following my own advice, this communication was reviewed for accuracy, prior to publication, by estate planning attorney Mr. Glenn Price, of Price & Farrington PLLC. Thank you to Mr. Price for his assistance.