Navigating State Estate Taxes

When mapping out an estate plan, many families take comfort in knowing the current federal estate and gift tax exemption is $15 million per taxpayer (2026). At this level, relatively few estates are subject to federal estate tax. However, avoiding federal estate tax does not necessarily mean your estate is tax-free.

As of 2026, 16 states and the District of Columbia impose their own state-level estate tax, inheritance tax, or both, often at exemption levels far lower than the federal threshold. For families living in, or owning property in, these jurisdictions, state estate taxes can represent a meaningful and often overlooked risk.

The "Decoupled" Reality: Why State Estate Taxes Exist

Prior to 2001, most states relied on a federal estate tax credit, commonly referred to as the "sponge tax," which allowed states to collect estate tax revenue without increasing the overall tax burden on residents.

That changed with the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which repealed the federal credit and replaced it with a deduction. To avoid losing revenue, many states responded by "decoupling" their estate tax systems from federal law.

As a result today:

• 12 states and the District of Columbia impose a stand-alone estate tax

• 5 states impose an inheritance tax, either in addition to or instead of an estate tax

• State exemptions are often dramatically lower than the federal exemption

• State tax rates, while generally lower than federal rates, can range from 0.8% to as high as 35%

Which States Impose a Transfer Tax?

If you live in or own real estate or closely held business interests in any of the following jurisdictions, state-level estate planning is essential:

States with an Estate Tax

Connecticut, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington

States with an Inheritance Tax

Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania

Planning Note

Maryland is unique in that it currently imposes both an estate tax and an inheritance tax

Three Core Goals of State Estate Tax Planning

For married couples residing in decoupled states, an effective estate plan generally seeks to accomplish three objectives:

1. Defer both federal and state estate taxes until the death of the second spouse

2. Fully utilize available federal and state estate tax exemptions

3. Create sufficient liquidity to pay state estate taxes without forcing the sale of family assets, real estate, or operating businesses

Trust Strategies to Minimize the State Tax Burden

One of the most common planning mistakes in decoupled states is relying solely on simple wills or portability elections. Most states do not allow portability of a deceased spouse’s unused state exemption, which can result in unnecessary taxes at the second death.

To address this, estate plans are often built around a revocable trust that divides into multiple irrevocable trusts at the first death, typically using the following structure:

• Credit Shelter Trust (CST)

  Funded with the maximum amount that can pass free of both federal and state estate tax. Assets, and all future appreciation, are excluded from the surviving spouse’s estate.
  

• State Marital QTIP Trust

  Funded with the difference between the state and federal exemptions. Many states allow a state-only QTIP election, deferring state estate tax at the first death while preserving the federal exemption.
  

• General Marital QTIP Trust

  Holds the portion of the estate exceeding the federal exemption, deferring both state and federal estate taxes until the surviving spouse’s death.

This approach allows families to preserve exemptions at both levels and avoid the "use it or lose it" trap common in state estate tax planning.

Creating Liquidity with Life Insurance

Even with optimal trust design, high-net-worth families in decoupled states may still face a substantial state estate tax bill at the second death. The key question then becomes: How will the tax be paid?

Life insurance can provide an elegant and simple solution:

• Income tax-free death benefits provide immediate liquidity

• When owned by an Irrevocable Life Insurance Trust (ILIT), proceeds are generally excluded from the taxable estate

• In inheritance-tax states, life insurance proceeds are often fully exempt, even when the policy is owned by the insured

This liquidity can be used to pay estate taxes, equalize inheritances, or preserve family businesses and real estate holdings.

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For families living in states with estate or inheritance taxes, federal exemption planning alone is not enough. A coordinated strategy - combining trusts, state-specific elections, and properly structured life insurance - can significantly reduce taxes and protect long-term family wealth.

This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.