An estate plan that avoids federal estate tax may face state estate levies. By Susan B. Garland, Contributing Editor August 6, 2009 EDITOR'S NOTE: This article was originally published in the June 2009 issue of Kiplinger's Retirement Report. To subscribe, click here.Before the year is out, expect to see Congress put the kibosh on the scheduled expiration of the federal estate tax. Lawmakers will likely vote to keep the exemption at the current $3.5 million for individuals and make it easier for married couples to leave $7 million to their heirs tax-free. Only estates that exceed the exemption amount owe the federal tax. But beware: The District of Columbia and 16 states impose their own estate levies (see the chart below). In almost all of these states, the exemptions are lower than $3.5 million, which means your heirs could be on the hook for state taxes if you don't seek estate-planning help. "You may think, 'I have a $3 million estate -- I don't have to worry,'" says Bruno Graziano, an analyst at CCH, a provider of tax information. "You can't be complacent." Consider how the estate tax works in New Jersey, which imposes a tax on estates worth more than $675,000. The rates range up to 16% for estates worth about $10 million. An estate worth $3.5 million would pay no federal tax, but would owe more than $230,000 in state estate taxes, according to David Whitlock, an estate-planning lawyer in Paramus, N.J. Advertisement Until several years ago, state estate taxes were not a problem. The federal government provided a state estate-tax credit, which allowed estates to reduce the federal tax bill by the amount paid in state estate taxes. The states set their estate taxes to match the maximum credit, claiming dollars that would otherwise go to federal coffers. In 2005, that credit was repealed. Facing a revenue decline, a number of states imposed their own estate-tax systems that operate separately from federal tax laws. If you're a married couple with a relatively large estate, you may already have a bypass trust, also known as a credit-shelter trust. But the trust is probably geared to the federal exemption, so you'll need to get it updated. A husband or wife can leave an unlimited amount to a spouse free of federal taxes, but the trust is designed to preserve more for the couple's heirs. For instance, if a husband dies this year with an estate of $7 million, he can leave it all to his wife tax-free. But if there's no trust and she dies with the $7 million intact, only $3.5 million can be protected by her exemption. When she dies, her estate will pay a 45% federal tax on the $3.5 million balance. Advertisement But a bypass trust can allow the full $7 million to go to the kids. The husband leaves $3.5 million to the trust, and the remaining $3.5 million goes tax-free to his widow. When she dies, the $3.5 million in the trust goes tax-free to the trust beneficiaries and her $3.5 million is protected by her own exemption. In many states today, though, funding a bypass trust with the federal $3.5 million exemption would leave the estate open to state taxes on the amount above the state exemption. Married couples now need to decide whether it makes more sense to fully fund the trust up to the federal exemption and pay state taxes, or fund it to the state level and leave the money possibly exposed to federal taxes when the second spouse dies. Strategies to Avoid State Taxes Dan Daniels, an estate-planning lawyer at Wiggin and Dana, a law firm with offices in Connecticut and New York, offers two examples. Say a couple has a $7 million estate and live in Connecticut, where the state tax kicks in when the value passes $2 million. The husband dies first. If the estate plan calls for $3.5 million to go to a bypass trust, the estate will owe state tax on the $1.5 million over the $2 million Connecticut exemption. The tax would be about $230,000. "Paying several hundreds of thousands of dollars in state taxes could be a rude awakening for a spouse," says Daniels. When the wife later dies, another $230,000 in Connecticut tax is due, but the balance of the $7 million estate will go to her heirs free of federal tax. Advertisement To avoid the first state-tax bill, this husband could fund the trust only up to the $2 million state exemption and leave the remaining $5 million outright to his wife. When the husband dies, no tax would be due. But when the wife dies, her kids will pay state tax on $3 million (the difference between the $5 million that the husband left outright to the wife and the $2 million state exemption) as well as federal tax on $1.5 million (the difference between the $5 million and the wife's $3.5 million federal exemption). The approximate total of state and federal taxes: nearly $900,000. The decision to fund a trust up to the state or federal exemption could partly depend on the age of the surviving spouse, says Daniels. "If the wife is young, she may not want to pay taxes sooner than she needs to and lose the possible investment returns she could have received on the money used to pay tax," he says. If she is 85 years old, the couple could decide to go with the first scenario and save the heirs the bigger tab, he says. If the estate is smaller, the considerations would be different. For example, if the total estate in Connecticut is worth $4 million, a husband who funds a trust at $3.5 million will leave his wife with a state tax bill on his death. But if he funds it at $2 million, his wife will pay no state tax, and the kids will not pay state or federal tax when the $4 million is left to them. Single people can't protect their property with bypass trusts. But Graziano says that they can take other measures to reduce the size of their taxable estates. One option is to give money to heirs now. Say you have a $3 million estate and live in Illinois, which has a $2 million state estate-tax exemption and no state gift tax. You could give your heirs $1 million (protected by your $1 million federal lifetime gift-tax exclusion) and reduce your estate to $2 million, leaving heirs an estate free of state and federal taxes, he says. If you own property in two or more states -- and at least one has an estate tax -- planning could be tricky. Consulting an estate-planning expert would be wise. Advertisement In addition to estate taxes, some states impose an inheritance tax, which depends on who gets the property. The states with inheritance taxes are Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee. Update: As of July 1, Delaware joined the list of states that have a state estate tax. The new Delaware estate tax will be imposed on estates of $3.5 million and more, the same exemption as the federal estate tax. The Delaware tax applies to those who died on or after July 1, 2009. For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger's Retirement Report.