May 01, 2023
Three Planning Techniques for Minimizing State Income Tax
The recent release of the Biden Administration’s fiscal 2024 revenue proposals — and the possibility of individual tax changes — emphasizes the need for proper estate and financial planning, with an eye on income tax. The increased federal estate tax exemption amount in 2023 may help relieve some of the burden of federal estate tax liability, and depending on your state of domicile, asset transfer at death may be tax-free. However, that leaves open the need for a strategy to address state income tax.
Here, we explore three techniques that may reduce state income tax liability.
Section 529 Planning
For parents and grandparents, a 529 plan or qualified tuition plan is a tax-advantaged way to save for a child’s college education. Income from assets in these plans is not taxed so long as the funds are eventually withdrawn and used for “qualified education expenses.” In the past several years, the class of these expenses has been expanded to include not only college tuition but also apprenticeship fees, qualified student loan payments and $10,000 per student per year for K–12 tuition. Although 529 accounts were originally intended to provide those who would not otherwise save for higher education expenses with a state tax-incentivized manner to do so, these plans are now used to create a number of tax efficiencies at both the state and federal levels.
Withdrawals used for qualified education expenses are free from federal income tax, and most states offer state income tax deductions or credits for contributions to a 529 plan. The amount of your 529 state tax deduction will depend on where you live and how much you contribute to such a plan during a given tax year.
Over 30 states, including the District of Columbia, currently offer a state income tax deduction or tax credit for 529 plan contributions. Most states offering such a deduction require the contribution be made to an in-state plan. In the majority of states, the full amount or a portion of your 529 plan contribution is deductible in computing state income tax. However, three states — Indiana, Utah and Vermont — offer a state income tax credit for 529 plan contributions. Minnesota taxpayers are eligible for a state income tax deduction or credit, depending on their adjusted gross income. Four states — California, Hawaii, Kentucky and North Carolina — currently have a state income tax but do not offer a deduction for contributions.1 A few, including Pennsylvania and New Jersey, offer a deduction (although the amount varies by state) for a contribution to any 52 9plan, regardless of where it’s based. New York allows a deduction for contributions to in-state plans only. The number of states imposing income tax on withdrawals for qualified loan payments remains fluid as states pass legislation to conform to federal rules. Consult with your local tax counsel if you have questions or concerns.
The definitional expansion of “qualified higher education expenses” to include private and parochial K-12 education allows residents of some states to augment the state income tax savings from the plan. Instead of making contributions that will accrue in the 529 account for the long term, you can make a contribution and withdrawal to pay for K-12 tuition expenses within a very short period of time. In essence, this enables the payment of private school tuition with tax deductible dollars.
529 Plan Example
In a high net worth family, parents and grandparents might both contribute to a child’s 529 plan up to the annual exclusion amount ($17,000 per recipient in 2023). Of the funds contributed (depending upon the plan and the domicile of the taxpayer contributors), some or all may be deductible for state income tax purposes. The bulk of the contributions are left to accrue in the account for use at a later date, and $10,000 is withdrawn that year to pay for private elementary school. In a best case scenario, grandparents can pay the balance of the tuition still outstanding directly to the institution and no one uses federal estate tax exemption.
Incomplete Gift Non-Grantor (ING) Trust Planning
Assets transferred to an ING trust are not completed gifts for gift tax purposes, yet the trust is a separate taxpayer for income tax purposes. As a result, an ING trust can serve to eliminate state income tax on the assets in the trust. Assume, for example, that you live in a high income tax state and wish to defer or eliminate state income tax but don’t wish to, or can’t afford to, part with the assets you intend to use to fund the trust. You could create an irrevocable trust in a state imposing no income tax on trust income and retain some measure of control over trust assets in the form of a limited testamentary power of appointment or the like. Your retained interest must be sufficient to ensure the funding of the ING trust fails to rise to the level of a completed gift.2
Because the trust must avoid grantor trust status to escape taxation on your personal return, the state must be one in which self-settled spendthrift trusts are permitted by statute. The importance of the choice of state situs is crucial since the success of the technique rests on the trust remaining a non-grantor trust during the grantor’s lifetime. These trusts are generally established in Nevada or Delaware; however, they can be set up in any state that has a Domestic Asset Protection Trust statute and no state fiduciary income tax.3 You may receive distributions from the ING trust, but only with the approval of an “adverse party,” which usually means a distribution committee comprising the trustee, a trust protector and other beneficiaries whose interests in the trust conflict with yours.
Frequently, an ING trust is funded with highly appreciated assets that would, if sold by the grantor, result in state-level income tax. After creation of the ING trust, when the trustee sells the appreciated asset inside the trust (ideally much later in time), no state income tax liability should result. Of course, federal tax will be owed at the trust level. Distributions to you from the ING trust are also intended to escape the imposition of state income tax.4
However, as beneficial as an ING trust may be, there are some pitfalls for the unwary:
- The trust must not be subject to tax in your state of domicile. If you live in a state that treats all trusts created by state residents as “resident trusts,” regardless of where the trust is created, then the trust will not escape state-level tax. Ohio, Pennsylvania, Washington, D.C. and Connecticut fall into this category.
- You must construct the ING trust structure well in advance of an asset sale for the sale to avoid challenge as a step transaction once an appreciated asset is sold inside the trust.
- In states in which “exception creditors” can reach the trust assets (e.g., for alimony or child support), it’s conceivable the trust may be considered a grantor trust.
An ING trust is not a wealth transfer vehicle, nor is it designed to reduce transfer tax liability. The assets of the ING trust may be includable in the estate of the grantor based on the incomplete nature of the gift. Though it seems unlikely, the IRS has not resolved whether estate tax inclusion of trust assets could result for members of the trust distribution committee or trustees as a result of the approval or veto power they hold over discretionary distributions.
That being said, we believe the potential for upside at both the state and federal level may be worth the risk. Because the assets are included in the grantor’s estate for federal estate tax purposes, after the lifetime of the grantor, all assets contained in the ING trust receive a step up in cost basis for income tax purposes. And with recent limitations on state and local tax deductions from the federal income tax, the state income tax savings of an ING trust may be amplified.
It’s overstating the obvious to say that the simplest state income tax planning strategy is to not be a resident of a state imposing a personal income tax. Successfully exiting a state imposing a personal income tax in favor of a state that does not stands to streamline and increase the efficiencies of available tax planning opportunities.
If you’re considering making the move to another state, be sure to conduct your own domicile analysis before the state you depart does it for you. Expect the state you exit to review whether you have demonstrated the intent to return, the amount of time you actually spend in your new state, your contacts in both states, where your family is and more. Testimony is often the most compelling factor in evaluating intent after the fact; consider whether you have a believable story in which you’re emotionally invested and that’s supported by your actions. Understand the criteria and risks of making the move from a taxing state to a nontaxing state, and prepare accordingly.
Earned income may pose an additional hurdle. If you extricate yourself from an income tax state, be prepared to still pay tax on the income you earn there, or in any other state imposing a personal income tax. For retirees, the situation becomes a little easier. Certain states will facilitate residency attempts by high-tax states’ refugees with affidavits or declarations of domicile that can be recorded or filed.5 These receive varying degrees of deference from auditing states.
Domicile may be the best state income tax planning technique there is, but it isn’t necessarily a slam dunk. If you enter into a change of domicile sincerely and adhere to the framework consistently and earnestly, you could expect positive results.
The three techniques discussed here present opportunities you may not have known existed. If you have any questions, please don’t hesitate to reach out to your Glenmede Relationship Manager or visit us at www.glenmede.com.
1 Information on how 529 plan state income tax benefits work and a breakdown of potential annual tax savings by state can be found at https://www.
2 Cline, Christopher P. “Dynasty Trusts,” 838-2nd Tax Mgmt. (BNA) Estates, Gifts, and Trusts, at E-Incomplete-Gift Non-Grantor Trusts.
3 Oshins, Steve. “8th Annual Non-Grantor Trust State Income Tax Chart.” Law Offices of Oshins & Associates, LLC, May 2022.
4 Karibjaian, George D., and H. H. Mensch. “State Income Tax Planning for the Nonresidential Floridian: The ING Trust. “The Florida Bar Journal Tax Law Section.
5 Robinson, M. Tax Cure Blog. https://taxcure.com/blog/can-you-avoid-state-income-tax.
This material provides information of possible interest to Glenmede’s clients and friends, and does not provide investment, tax, legal or other advice. Any opinions, recommendations, expectations and/or projections expressed herein may change after the date of publication. Information obtained from third-party sources is assumed to be reliable but may not be independently verified, and the accuracy thereof is not guaranteed. Any potential outcome discussed, including but not limited to performance, legislation or tax consequence, ultimately may not occur due to various risks and uncertainties. Clients are encouraged to discuss any matter discussed herein with their tax advisor, attorney or Glenmede Relationship Manager.