Unfortunately, no the Estate Tax Exemption does not solve or eliminate all the potential tax problems for your estate or your family. You should never rely on a large estate tax exemption as your reason not to do proper estate planning. First, the estate tax (death tax) exemption is not automatic and its application can be complicated. Your available exemption amount can be reduced by gifts given during your entire life if done incorrectly. Even if you have a small estate, documents must be filed in a timely manner in order to take advantage of the exemption amount. Depending on your state, you may have to deal with both federal and state death taxes, with different exemption amounts. And of course, the exemption amount in effect today, may not be the amount in effect when you die.
Secondly, even if your estate is exempt from the death tax, there are many other types of taxes that can negatively impact your estate, your spouse, and your heirs. There are income tax, capital gains tax, gift tax, and property tax issues, just to name a few. Many of the do-it-yourself probate avoidance techniques can result in significant capital gains taxes for your heirs. If structured properly, an estate plan can reduce or eliminate all capital gains taxes for your heirs. Transfers of assets before death can also result in significant gift taxes for the giver of the gift. In some states, the improper transfer of real estate can drastically increase your heirs’ property taxes.
A quality estate plan can significantly reduce or eliminate these other taxes for your spouse and children during the years following your death. Of course, the state and federal tax laws are always changing. Just because you qualify for an exemption this year, can you be sure you will qualify for an exemption (or that there will even be one) the year you die? Only the law in effect the year you die matters. A proper trust-based plan, with a Formal Maintenance Program is the only way to ensure your estate will take advantage of the tax laws in effect when you die. If the tax law changes, will you know or have time to get an estate plan before you die? The current Estate Tax is 40% of everything in your estate, and the capital gains rate is 20%. So, the cost of procrastination or the failure to plan can be high.
The personal estate tax exemption. The personal exemption allows a set dollar amount of property to pass tax-free, no matter who inherits it. Thanks to the Tax Cuts and Jobs Act of 2017, the individual exemption for deaths in 2022 is $12.06 million. This amount rises each year with inflation. If your estate is worth less than the exemption amount—as are the estates of more than 99.9% of the population—it won’t owe federal estate tax when you die. If you have made taxable gifts during your life, the amount of your personal exemption will be reduced by the amount of those taxable gifts. The marital deduction. All property left to a surviving spouse passes free of estate tax; this is called the marital deduction. The marital deduction is not allowed for property left to noncitizen spouses, but the personal estate tax exemption can be used for property left to noncitizen spouses.
Special rules for married couples. A surviving spouse gets a big tax break. If the deceased spouse didn’t use up his or her individual tax exemption, the survivor can use what’s left. That gives the couple a total exemption of twice the individual exemption amount, which can be split between them in any way that provides the greatest tax benefit. For example, say a man dies and leaves $10 million to his widow; no estate tax is owed because property left to a spouse is tax-free. The widow then dies, leaving $20 million (her own $10 million plus the $10 million she inherited from her husband) to their children. Her estate won’t owe any estate tax, even though the estate is over the exemption amount, because the estate can use some of the husband’s unused exemption.
If you think your estate will be large enough to trigger federal estate tax, get advice from an experienced estate planning lawyer who can help you sort through your options. There are a few estate planning tools you can use to reduce estate tax liability.
State estate and inheritance taxes. Even if your estate isn’t big enough to owe federal estate tax, the state may still take a bite. Many states collect either their own estate or inheritance taxes.
As you might expect, most people aren’t exactly thrilled at the proposition of paying estate taxes after their death. In turn, there are a number of strategies you can use to minimize what you owe or avoid estate taxes altogether.
One way to get around the estate tax is to hand off portions of your wealth to your family members through gifts. For tax year 2021, you can give any one person up to $15,000 tax-free (or up to $30,000 if you’re married and you’re filing joint tax returns). Over the course of your lifetime, you can give out up to $11.7 million of your wealth as gifts before getting hit with the gift tax. There’s no limit to the number of people you can give gifts to within a single year. So if you have an $18 million estate, you can gradually pass on your assets to your loved ones until the net value of your estate is less than (or equal to) $11.7 million. Just keep in mind that the $11.4 million threshold applies to both the gift tax and estate tax at the same time.
If you don’t want to leave your family members in a difficult financial situation after you die, it’s a good idea to buy life insurance. Life insurance proceeds generally aren’t taxable. But after you pass away, they could become part of your estate, which is subject to taxation. To avoid having your life insurance proceeds taxed, you can create an irrevocable life insurance trust. You’d essentially be setting up a trust and transferring the ownership of it to another person. The trust is irrevocable because in the future, you wouldn’t be able to make adjustments to it without the consent of the trust’s beneficiary. By transferring over your life insurance policy, your death benefits wouldn’t be part of your estate. It’s best to do this sooner rather than later, however. If you die within three years of making the transfer, your life insurance proceeds would still be considered part of your taxable estate.
Another way to bypass the estate tax is to transfer part of your wealth to a charity through a trust. There are two types of charitable trusts: charitable lead trusts (CLTs) and charitable remainder trusts (CRTs). If you have a CLT, some of the assets in your trust will go to a tax-exempt charity. By donating to charity, you’ll lower the value of your estate and end up with an extra tax break. Once you die (or after a pre-determined period of time), whatever’s left in the trust will be passed on to your beneficiaries.
On the other hand, if you have a CRT, you can transfer a stock or another appreciating asset to an irrevocable trust. Throughout your lifetime, you can make money off of that asset. And then when you die, your investment income will go to charity. In the process, you’ll avoid the capital gains tax and lower your estate tax burden. Plus, you’ll score a tax deduction.
If there are any family-owned businesses or assets (such as properties) that you want your children to own after you’re gone, you can set up a family limited partnership. Typically, this involves establishing a general partnership and then making heirs and family members limited partners.
As the general partner, you’ll still be able to call the shots. But your partners (whether they’re your children or another relative) will have a stake in your company or own a portion of your assets. As a result, the size of your estate will be smaller.
An additional way to reduce the number of assets that will be subject to the estate tax is to fund a qualified personal residence trust (QPRT). With a QPRT, you’re transferring the ownership of your home into a trust. During the trust’s term, you can continue living in your home without paying rent. After that term ends, your beneficiaries can take over your property. Through a QPRT, you can freeze your primary residence and/or vacation home’s market value and avoid paying the gift tax (as long as you haven’t exceeded the lifetime limit for taxable gifts). You’ll also immediately reduce the size of your estate. Unfortunately, if you die before the end of your trust’s term, your home will still be part of your estate. And while you can create a trust for your house with a mortgage, it’s easier to set up a QPRT for a rental property.
How Can A Trust Reduce My Estate Tax?
Trusts are a common way of reducing or eliminating both estate and gift taxes. A trust is a property arrangement in which a grantor transfers assets to be managed by a trustee for the benefit of a beneficiary. Though there are many kinds of trusts, they all transfer ownership of the assets from the grantor to the trust itself. Because the grantor and the beneficiary do not themselves own the assets, they can avoid or reduce taxes. Below are four kinds of trusts that may be used for this purpose.
Also known as a “bypass” trust, an A-B trust actually involves two trusts (the “A” and “B”). Upon the death of a spouse, the “decedent’s trust” (B) is funded with an amount up to that tax year’s estate tax exemption and the “survivor’s trust” (A) is funded with the remainder of the married couple’s assets. The unlimited marital tax exemption ensures that the A-trust assets are only taxed when the survivor dies. The survivor receives income from the B-trust as a beneficiary during their lifetime, after which the next beneficiaries in line (normally the couple’s children) reap the fruits.
A QTIP trust also allows a deceased person to ensure that their surviving spouse receives trust income as a beneficiary. At the same time, the decedent controls who receives the assets when the survivor dies. For example, they can name children from a previous marriage as residual beneficiaries. Again, the unlimited marital exemption ensures that assets are only taxed upon the surviving spouse’s death.
By giving large assets (e.g., a highly appreciated real estate investment) to a tax-exempt charity, you remove the asset from your estate and thereby avoid the estate tax. If the charity then sells the asset and reinvests the proceeds, it will also avoid the capital gains tax. Although you relinquish control of the asset, you can receive lifetime income from trust investments by naming yourself as a lifetime beneficiary. The “remainder” when you die goes to the charity.
This kind of arrangement transfers your life insurance policy out of your taxable estate and into the trust. The life insurance proceeds generated when you die are also kept out of your estate. Although you relinquish control of the trust once it is made, you can name beneficiaries
and specify how the assets should be handled within the trust formation document.
Note that trusts used for tax purposes must generally be “irrevocable,” meaning that the trust terms cannot be changed once they go into effect. This ensures that the assets are truly and meaningfully removed from the grantor’s estate because the grantor fully relinquished control.
Because they cannot be changed, irrevocable trusts should be created with caution. A tax professional and estate planning attorney can help you understand the pros and cons of using a trust for tax purposes.