Smart Tax Strategies for Your Estate Plan
- A solid estate plan can help reduce the amount you pay in taxes and leave more for your heirs.
- Take advantage of the annual gift tax exemption that allows you to transfer up to $14,000 per person per year and will not count toward your lifetime gift exemption of $5.34 million.
- Consider life insurance to increase the liquidity of assets such as a business or real estate.
With a gift and estate tax of 40%, a little planning can go a long way in terms of tax savings. Here are some smart strategies to get you started:
Transfer wealth in your lifetime
When it comes to minimizing transfer taxes, lifetime gifts are generally better than testamentary gifts because they reduce the size of your taxable estate. Currently, you can give up to $14,000 to any number of persons in a single year without incurring gift tax ($28,000 for spouses splitting gifts). Additionally, you can give away a total equal to the lifetime gift tax exemption amount before any gift tax is due. Keep in mind that the unified tax credit of $5.34 million includes both the lifetime gift tax exemption and the estate tax exemption, and an increase in one will reduce the other.
Tip: Make unlimited payments directly to qualified medical and educational providers on behalf of your loved ones, and preserve your lifetime exemption. The lucky recipient of the gift owes no gift or income tax. You get to see the enjoyment of your gift, plus transfer future appreciation of the gift to the beneficiary.
Here are a couple of things to remember about lifetime gifting:
- Leave yourself enough to live on. The gift has to be irrevocable, so don't give until it hurts. Plan carefully with a tax professional.
- Stay current on the law. If estate taxes are reduced or repealed in the future, as they have in the past, you may regret having paid gift tax now in an effort to minimize your estate tax. Take into account possible changes in tax code when you time your gifts and wealth transfers.
Take care of your surviving spouse
In the past, spouses sometimes used a credit shelter (bypass) trust to preserve the first-to-die's estate tax exemption. Assets beyond that estate tax credit would pass to the surviving spouse outright, or via a marital trust, without any current estate taxation (for U.S. citizens). One important reason to set up a marital trust is that, a surviving spouse can take advantage of the deceased spouse's estate tax exemption without having a bypass trust in place.
Take care of your spouse and children from a prior marriage
With a qualified terminable interest property (QTIP) trust—the most flexible marital trust—the executor decides how much of the estate qualifies for the unlimited marital deduction. The surviving spouse's needs and expenses are still taken care of during his or her lifetime, but the eventual distribution of trust assets to the first spouse's children is protected. This trust is especially attractive for people with children from a prior marriage, or if there's concern over what might happen if a surviving spouse remarries.
Capitalize on a valuable home while you're still living there
A qualified personal residence trust (QPRT) allows you to transfer a residence into a trust for gift purposes, while retaining the right to live there for a period of years. At the end of the term, the residence is transferred to the beneficiary.
Tip: Use the QPRT strategy when interest rates are high, because a higher discount rate (determined by the IRS) means that the present value of the home subject to gift taxes is lower. Here's what makes this strategy effective: For gift tax purposes, the transfer is calculated as the present value of the remainder interest. The right to stay in the house has value, which is also deducted from the gift. What's more, any future appreciation after the transfer to trust is not included in the grantor's estate. The grantor may arrange to stay in the house at the end of the term at fair market rent. One caveat: The longer the term of the QPRT, the smaller the gift will be for tax purposes. And the grantor must outlive the trust's term or the home value will revert to the estate, so plan for that trade-off.
Minimize gift tax value
With a grantor retained annuity trust (GRAT), the grantor transfers assets to a trust for a few years. During the term, the grantor receives an annuity from the trust. At the end of the term, the remaining assets pass to the beneficiary.
The annuity payments reduce the gift's value for gift tax purposes; the value is determined at the time of transfer into the trust. As long as the assets in the trust outperform the discount rate (or hurdle rate), this can be an extremely effective transfer strategy.
Tip: Use a GRAT in a low-interest-rate environment because the assets have a better chance of beating the hurdle rate. GRATs also work especially well with assets currently depressed in value but with the potential for significant appreciation.
Have more control over the time period of your gift
In order for a gift to qualify for the annual $14,000 exclusion, it must be a "present interest," not a "future interest." In other words, the recipient must be able to use or spend the gift immediately, with some exceptions for gifts to children.
The Crummey power trust (named after the taxpayer who first used the strategy) allows transfers to the trust to qualify as a present interest. Also, you can decide when and how the beneficiary ultimately receives control of the assets.
The beneficiary of a Crummey power trust has a limited period of time during which he or she can withdraw the annual gift from the trust, after which the gift becomes subject to the provisions and terms of the trust. As long as this "Crummey power" is available, whether or not it's exercised, the gift creates a present interest and qualifies for the grantor's annual gift tax exclusion. Crummey powers are often used with irrevocable life insurance trusts (below).
Transfer wealth from illiquid assets
Life insurance is often used in estate planning to provide liquidity in the case of closely held or hard-to-sell assets (a family business, family farm, significant real estate holdings, etc.) or as a wealth replacement vehicle to provide for family members in the face of estate tax liabilities or charitable bequests.
However, though life insurance proceeds are generally tax-free income to the beneficiary, they're included in the decedent's gross estate as long as the decedent owns the policy or has any incidents of ownership within the three years preceding his/her death. The most effective way to avoid this problem is with an irrevocable life insurance trust. As long as the trust owns the policy, the proceeds are outside the estate and will pass free of both income and estate taxes.
Tip: Have your irrevocable life insurance trust purchase your life insurance policy, because the transfer of an existing policy within three years of death will bring the proceeds back into the estate.
Maintain family assets and relationships
A family limited partnership (FLP) can be an effective way to manage and control family assets while providing for the tax-effective transfer of wealth to others. In the typical arrangement, mom and dad gift the majority of the partnership to family members in the form of limited partnership interests. Because limited partners have no say in running the partnership and usually can't sell or borrow against their interests, valuation discounts arising from lack of liquidity and marketability will apply for gift tax purposes. Additional valuation discounts may apply to the assets themselves (for illiquid small business or undivided interests in real estate, for example).
Be sure to consult with a tax professional or an attorney if you have a complex or unique situation. A professional will be able to identify the large array of strategies and tools to help manage estate taxes.
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This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The strategies mentioned here may not be suitable for everyone. Each investor needs to review an estate strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.