Tax Strategies For Estate Planning: Mitigating Your Tax Exposure
You've probably heard about a “death tax” and how your heirs may owe Uncle Sam money when they inherit your estate. Is it true? Will you still pay taxes after you die?
It all depends.
Estate planning (or wealth transfer - as we like to call it) is an essential part of wealth management. While many think of estate planning as only applicable to the wealthiest Americans, everyone should consider basic estate planning principles. Doing so could help you minimize potential taxes, limit the chances of court involvement, and ensure that your assets are passed along in accordance with your wishes.
In this article, we’ll discuss some common estate planning tax strategies and how they can mitigate your tax exposure.
Will You Be Subject to Estate Taxes?
If you're like most Americans, you don't need to worry about the estate tax. Current law exempts all but about 0.1% of American estates from federal estate taxes.
The breakdown in 2021 looked like this:
3.4 million Americans passed away in 2020.
Just 3,441 heirs had to file an estate-tax return with the IRS.
Only 1,275 people actually had to pay an estate tax.
The IRS collected $9 billion in estate taxes.
In October 2022, the IRS increased the estate-tax exclusion from $12.06 million to $12.92 million for 2023. That means that unless you plan to leave nearly $13 million to your heirs — $26 million if you're married — then you're safe from federal estate taxes.
However, some exceptions to federal law may still affect your estate plan, depending on where you live. These include your individual state's estate taxes and any applicable state inheritance taxes.
As of 2022, 11 states have their own estate tax, five more have an inheritance tax, and one state (Maryland) imposes both taxes. These are in addition to what the U.S. federal government may charge. Each state's tax may have a different threshold than the federal exemption level. To complicate things even further, many states offer their own set of exclusions and deductions with respect to these types of state-level death duties.
California does not charge an estate tax. Residents of our state only pay federal estate taxes if it applies.
In addition to state inheritance taxes, there may also be estate taxes levied by other countries where you hold real assets.
If you are concerned that your heirs may owe federal or state estate taxes, you may be able to minimize their risk through careful estate planning. Consider consulting with a qualified advisor before making decisions about your assets.
How Much Will Your Estate Pay in Taxes?
The IRS uses a graduated rate table where the rate increases as the taxable amount increases. In each case, you would pay a base amount plus a marginal rate. For example…
If your taxable amount falls between $0 and $10,000, you would pay nothing on the base and 18% on the taxable amount.
If your taxable amount falls between $10,001 and $20,000, you would pay $1,800 base tax and 20% on the taxable amount.
If your taxable amount falls between $20,001 and $40,000, you would pay $3,800 base tax and 22% on the taxable amount.
If you’re married, estate taxes can apply as soon as one spouse passes away provided their assets exceed $12.06 million (although this threshold will increase in 2023). However, you can transfer everything to your spouse with no estate tax and without using any of your exclusion amount. Generally, assets transferred to anyone other than your spouse will count towards your $12.06 million exclusion amount.
If you're married, your spouse can "inherit" any exclusion amount you did not use by electing portability (i.e. your combined limit is doubled, which could allow for transfers of roughly $26 million in 2023).
How the New SECURE Act Affects Estate Taxes
Some people expect to leave their retirement savings accounts to a spouse or dependent, thinking this will help lower the overall income taxes paid on an IRA. The only way this approach works as a tax strategy, however, is if your beneficiary is in a lower tax bracket than you.
Be careful, though! A 2019 law called the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) has changed long-standing rules about inherited IRAs. With some exceptions, beneficiaries who inherit an IRA or 401(k) will now be required to withdraw the inherited funds from the account in the next 10 years. This could push them into a higher tax bracket.
As for leaving your retirement account to a spouse… while often wise, that approach is unlikely to provide a tax benefit.
IRA holders may avoid the SECURE Act's new requirement either by setting up a particular trust. Not all trusts avoid the 10-year rule, though. Some trusts, often referred to as See-Through trusts, may qualify provided they meet certain IRS rules. You may also avoid the 10-year rule if the beneficiary of your IRA is your spouse, disabled, chronically ill, not more than 10 years younger than the decedent, or in the case of certain minor children.
While these strategies may work for you, it is a good idea to talk to your wealth management professional and your estate-planning attorney before making any changes.
The Benefits of Creating a Trust
If you have an estate with significant assets and you have children, a trust can offer you a number of benefits, including asset protection and third-party management of your assets after you pass away. A trust may also let your beneficiaries avoid probate.
Some trusts can provide significant tax benefits to those who will ultimately receive them, including a spouse. Before you set up a trust, please consult with a professional about estate planning strategies to learn more about how trusts can minimize the impact taxes have on your legacy. A trust can offer many benefits, but it may not be the best approach for everyone.
Other strategies may include making gifts to your prospective heirs while you are still alive.
Should You Give Assets to Your Heirs While Still Alive?
Some people want to avoid estate taxes by giving their heirs some money while they're still alive. Doing so may help mitigate future taxes on capital gains and appreciation. You may want to see your children or grandchildren benefit from the money rather than waiting until you've passed away to give it to them.
Doing so may also be an opportunity for you to prepare them and to see how your heirs handle money before you dump a large lump-sum amount on them.
As a tax strategy, however, this approach offers few returns. First, as we mentioned above, unless you are in the top 0.1% of Americans by wealth, you are not likely to pay a federal inheritance tax. Most states do not impose an inheritance or estate tax, either, so your heirs will probably take home your full estate anyway.
It's worth a conversation with your financial advisor and your tax preparer.
What is the Gift Tax?
When one person gives an item of value to another person without receiving anything in return — or receiving less than the full value — the IRS considers this a gift and may impose a gift tax. This can include gifts of money, stocks, or real estate. It can even include zero-interest loans. While the estate-tax exemption counts toward gift taxes, there is also an annual gift tax exclusion. So unless you are gifting someone several million dollars, you are probably not going to pay gift taxes. You may, however, need to file an extra tax form, so if you're gifting more than the annual exclusion amount be sure to mention this to your CPA.
What is the Generation-Skipping Tax?
The generation-skipping tax assesses a flat 40% tax when assets are transferred or gifted to a "skip person." A skip person is someone two or more generations younger (i.e. when not transferred directly from parent to child).
This tax also applies to any gifts made during your lifetime or after death. It became federal law in 1976 to prevent very wealthy Americans from avoiding estate taxes by naming their grandchildren as their sole beneficiaries.
Like the estate tax, the generation-skipping tax has an extremely high exemption amount — $12.06 million per individual in 2022 — so most people won’t have to worry about it.
Frequently Asked Questions About Estate Taxes
What are Estate Taxes?
An estate tax is a tax on your assets or estate when you die. As of 2022, the majority of Americans will not be subject to federal estate tax. Depending on where you live, your state may impose an inheritance tax, though.
Who Pays Estate Taxes?
Under current law, only about 0.1% of Americans actually pay estate taxes. These people have generally inherited more than $13 million. Unless you fall into this exceptionally wealthy class, your heirs are unlikely to pay any estate tax.
How Can I Make Sure My Heirs Avoid Probate?
One of the most common tax strategies for estate planning is to set up a trust. A trust can be designed to avoid probate and allow your heirs to access their inheritance without having to go through a lengthy court process. Setting up an irrevocable trust can also be beneficial if you live in a state that has an inheritance tax because it could help shelter some of your assets from taxation.
What is a Living Trust?
A living trust is a legal document that is created to manage property for someone after their death. A living trust can be used in combination with other estate planning tools, like a will or other trusts, to ensure that your assets are distributed according to your wishes.
Can Cooke Wealth Management Help Me Create My Estate Plan?
Yes, while we do not draft legal documents, we will often help our clients with their estate planning. If you are interested in learning more about how we can help you, please call or email our office and schedule an appointment to meet with a member of our team.