MN Estate Tax Credit: Use It or Lose It!

Background

When a new family becomes a client, the first step is to initiate the consolidation of financial accounts and custodians. Our goal is to simplify, and clients love simplification. Anecdotally, we reduce the number of accounts by 50%.

Part of this consolidation process is preparing a balance sheet broken down by who owns what legally: Spouse 1, Spouse 2, or Joint tenancy. We then total up the amounts in each ownership category. Here are a few common ownership traits that can lead to an imbalance of assets between spouses which can cause a family to fall into an estate tax trap owing to inefficient use of the MN Estate Tax Credit. Here are some of the most common imbalances we see:

  • One spouse has far more retirement assets than the other
  • Frequently, one spouse only holds a legal interest in jointly titled property
  • Primary and secondary homes are frequently held jointly
  • Life Insurance is frequently held inside the taxable estate versus outside the estate in an Irrevocable Life Insurance Trust (ILIT)
  • One spouse may have various forms of deferred or equity compensation
  • Bank accounts and brokerage accounts are frequently non-optimally titled

Does this imbalance make a difference for Federal Estate Tax planning?

Generally not, and for three reasons:

  1. Many clients don’t need to worry about the Federal Estate Tax because it currently excludes a married couple’s first 24 million dollars.
  2. No matter who owns what dollar value of assets, or when they die, any unused portion of the Federal Estate Tax exemption (or credit) is transferred to the surviving spouse.
  3. Lastly, at the Federal level, the estate tax is not due until the second spouse dies.

So, does an ownership imbalance matter for MN Estate Tax planning?

Absolutely! Each spouse in MN has a 3-million-dollar MN estate tax exclusion (or credit). But, heads up, here’s the zinger: Unlike the federal estate tax exclusion, the unused portion of the MN exclusion is non-transferable to the surviving spouse, and the tax is due at the first spouse’s death.

  • If the first spouse to die has 1 million dollars in their name, then the remaining 2 million dollar exclusion is forever LOST. Yep, use it or lose it!
    • A 2 million dollar exclusion loss compounds tax into the future:
      • Assuming the 2 million dollars of lost credit grows in the surviving spouse’s estate to 4.79 million dollars at 6% interest, 15 years later, at the second spouse’s death, the family’s tax loss could be 16% X 4.79 million dollars or $767,000* payable to the MN Dept of Revenue within 9 months. Those are real dollars, perhaps great grandchildren’s college education.
    • Here’s another example: Suppose Spouse 1 dies first with 6 million dollars in their estate, but Spouse 2 believes that Spouse 1 only has 3 million dollars of assets in their name. The State of MN might ask, who owns the life insurance of 3-million dollars payable at Spouse 1’s death? Oops, gotcha! Spouse 1 owns the life insurance, so Spouse 1’s MN taxable estate is now 6 million dollars! Oh, but there’s more:
      • Unlike the Federal Estate Tax, in MN, the estate tax is due at the FIRST spouse’s death, NOT the second! So surviving Spouse 2 might owe approximately 13% of 3 million dollars, or $390,000, to the MN Department of Revenue.
        • The family in this example thought they had 3 million dollars of tax-free life insurance. They actually had $3MM – 390K estate tax = $2,610,000 of tax-free life insurance.
        • The fix to this problem is easy, but that’s another story for another blog.

So, is balancing assets between spouses an important tax planning concept in states like MN?

Broadly, yes! Specifically, giving financial advice to clients demands proactivity. Not only do our clients know where funds from equity compensation and bonuses will be invested before they are received, but they also know whose account will be funded to work toward optimal asset balance between spouses.

“Wait! I’m thinking about a divorce! No way I’m balancing my assets!”

Generally, this is a non-issue, and here is why. For the state of MN, if a divorce occurs, marital assets must be divided fairly and equitably. Only assets that are pre-marriage, or non-marital, are generally not divided between the spouses. Always seek advice from proper legal counsel.

For example, we might recommend moving funds from Spouse 1’s marital account into Spouse 2’s name with the lower asset total. If there is a subsequent divorce, all assets would still be included in marital assets that would be equitably divided. As Shakespeare would say: “much ado about nothing.”

Here are the states which currently have an inheritance or estate tax. Not all of these states operate exactly like MN:

  • Estate tax is levied at death upon the estate of the decedent: Connecticut, Hawaii, Illinois, Maine, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. Washington, DC also has an estate tax.
  • Inheritance tax is collected when a beneficiary inherits money, property, or other assets after someone dies. There is no federal inheritance tax, and only six states levy inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.

Ownership of assets and their implications for estate taxes can be a complicated issue. And to add complexity, the situation can change and does at the behest of federal and local legislatures! That is why we take the time and care necessary to educate our clients on the rules which will impact their financial futures and recommend solutions where we notice an imbalance. When life is busy, it is nice to know someone is taking a second, discriminating look at the ownership of your family’s assets.

*MN has a graduated estate tax matrix which starts at 13% of assets over the exclusion, and it quickly rises to the top marginal rate of 16% at about 10.1 million dollars.

Stoddard Barnhill, CFP®
sbarnhill@thebahnsengroup.com

Sarah Leitzke, CFP®
sleitzke@thebahnsengroup.com

Phillip Barnhill, CLU®
pbarnhill@thebahnsengroup.com

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About the Authors

Stoddard Barnhill, CFP®

Private Wealth Advisor

Sarah Leitzke, CFP®

Private Wealth Advisor

Phil Barnhill, CLU®

Director of Risk Management

For nearly 25 years Phil has worked exclusively with senior leaders of public and large private companies. Over the past seven years Stoddard has been carefully mentored in this niche market and is now mentoring Sarah, leading to a highly-specialized practice knowledge within the team. This focus on corporate executives and their family dynamics comes with significant insights into executive compensation, stock concentration, equity monetization, and the full life-cycle of a career in the C-Suite.

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