Now that the federal gift and estate tax exemption is permanently set at an inflation-adjusted $5 million ($5.25 million in 2013), many people are feeling more relaxed about the need for estate planning. But don’t overlook state death taxes. Without planning, these taxes could generate significant tax bills for your family.

Planning after ATRA

In early 2013, the American Taxpayer Relief Act of 2012 (ATRA) made the higher federal exemption amount permanent (it had been scheduled to drop to $1 million) and set the top estate and gift tax rate at 40%. The act also made permanent the concept of “portability,” which allows a surviving spouse to take advantage of a deceased spouse’s unused exemption. This means that married couples can give or bequeath up to $10.5 million without exposure to gift or estate taxes.

If your estate is under $5.25 million ($10.5 million for married couples), and you don’t expect it to grow beyond that threshold during your lifetime, there’s less pressure to implement sophisticated estate planning strategies to minimize or eliminate federal gift and estate taxes. But be sure to evaluate the potential impact of state death taxes on your estate. These taxes can be substantial, and in some states, they apply to every dollar of a bequest. (In other words, there’s no exemption.)

A state of flux

One challenge in planning for state death taxes is that they’re in a constant state of flux. Currently, more than 20 states and the District of Columbia have an estate tax, an inheritance tax or, in at least two cases, both. As the names suggest, estate tax applies to one’s estate and inheritance tax is imposed on those who inherit property.

Tax rates and exemption amounts vary from state to state and may change over time. Inheritance taxes often kick in with the first dollar of an inheritance, but some states offer exemptions for inheritances by certain family members (such as children, parents or siblings). In recent years, there’s been a trend toward softening the blow of state death taxes by increasing exemption amounts. Still, exemptions in many states are substantially lower than the federal exemption.

Suppose, for example, that you live in a state that imposes estate tax at a flat rate of 16% beyond an allowed $1 million exemption. If you die with $5 million in assets, your estate will escape federal estate tax but will be liable for state estate tax of $640,000 ($5 million less $1 million exemption = $4 million taxable × 16% tax rate = $640,000).

Planning strategies

To avoid surprising your family with an unexpected tax bill, it’s important to include state death taxes in your estate planning. Here are some strategies to consider:

Use a credit shelter trust. Traditional estate planning for married couples typically includes a credit shelter (or “bypass”) trust to preserve both spouses’ exemptions and defer estate taxes as long as possible. With higher exemption amounts and portability, this strategy is less critical today for federal tax purposes. But it still offers significant benefits for estate tax planning in some states.

Here’s how it works, assuming you have a $5 million estate and live in a state with a $1 million exemption: When you die, your estate plan transfers $1 million to a credit shelter trust, which is shielded from taxes by your exemption and provides your spouse with income for life (with the remainder going to your children). The other $4 million goes into a marital trust, which escapes taxation in your estate by virtue of the marital deduction. When your spouse dies, $3 million ($4 million less the $1 million exemption) will be subject to state estate taxes, but you will have used both of your exemptions and deferred state taxes until the second spouse’s death.

Give it away. Making gifts to your children or other heirs — either outright or in trust — is a simple but highly effective strategy. For federal tax purposes, you can make gifts up to your unused exemption amount tax-free. You can also use the annual federal gift tax exclusion to give up to $14,000 per person tax-free to any number of recipients. And direct payments of tuition or medical expenses also escape gift taxes.

Only two states have gift taxes: Connecticut and Minnesota. Connecticut’s tax kicks in after lifetime gifts reach $2 million, while Minnesota’s threshold is $1 million. In other states, you can make unlimited gifts to remove assets from your estate and minimize or eliminate state death taxes.

If you’re not ready to let go of your wealth, another option is a spousal lifetime access trust (SLAT). (See the sidebar “SLAT lets you have your cake and eat it too.”)

Relocate. Consider moving to one of the 20+ states without estate, inheritance or gift taxes (and, in some cases, without income taxes). Many of these states also happen to be attractive retirement destinations, so it’s an option worth looking at.

Review state laws

Regardless of your federal tax situation, it’s critical to consider the impact of state death taxes on your estate plan. Before you play down the importance of estate planning, review any estate or inheritance tax laws in the state where you live as well as any states in which you own property.

Sidebar: SLAT lets you have your cake and eat it too

For married couples, a spousal lifetime access trust (SLAT) can be a powerful tool for avoiding state death taxes. Because a SLAT is irrevocable, contributions to the trust are removed from your estate, reducing the amount of wealth exposed to state death taxes.

The trust is designed to benefit your children, but it also authorizes the trustee to make discretionary lifetime distributions to your spouse. So long as your marriage is strong, a SLAT allows you to shelter your contributions and any future appreciation in their value from state death taxes, while retaining indirect access (through your spouse) to the trust assets.