Editors' Note: This article is excerpted from The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book.
Most of us have come to fear estate taxes. But at least for now, federal estate taxes are an issue for the very wealthy only—or for those with an estate valued at more than $12.06 million (or $24.12 million for a married couple) in 2022. But before you crack open the champagne, a couple of caveats: First, we can never say never when it comes to Congress. The current tax rates are scheduled to "sunset" at the end of 2025 where they will revert back to 2017 levels (adjusted for inflation) under the Tax Cuts and Jobs Act (TCJA). However, anything can happen in the future. Second, even though you may not have to pay federal estate taxes, you may be on the hook for state taxes.
That said, the best you can do is plan with the information you have. Below I cover basics as well as strategies for anyone whose estate may still be impacted. But you should be aware that estate taxation—or just about anything having to do with estate planning— is complex. It’s always best to work with an experienced estate planning attorney.
THE FEDERAL ESTATE TAX SYSTEM: BASIC STRUCTURE
The federal estate tax is actually part of a larger system of taxation called the federal transfer tax system, made up of:
- The estate tax, which covers transfers of property at death.
- The gift tax, which covers transfers of property during a person’s lifetime.
- The generation-skipping transfer (GST) tax, which covers transfers of property to people who are one or more generations younger.
The estate and gift tax work hand in hand. Without the gift tax, individuals could give away all of their assets during their lifetime and avoid taxation. Without the estate tax, individuals could give away all of their assets at death without taxation. Therefore, estate and gift taxes are joined together into what is sometimes referred to as the federal unified transfer tax system. Both create an identical tax liability.
Estate and gift taxes share other characteristics as well:
- They use the same tax rate schedule.
- They share a credit (the applicable [or unified] credit amount) that reduces or eliminates a person’s tax liability. This credit allows for an applicable exclusion, a dollar amount that will not be taxed.
- Computation of both the estate and the gift tax is cumulative over one’s lifetime. A gift tax credit used in one year reduces the amount of gift tax credit that can be used in future years. The total gift tax credit used during one’s life reduces the credit available to use against his or her estate taxes.
- Both have marital and charitable deductions to reduce tax liability.
The GST tax, which has a flat rate, is separate from the unified tax system and is imposed in addition to estate and gift taxes. The purpose of the GST tax is to prevent families from avoiding one round of estate tax by transferring assets to grandchildren instead of to children. The government adds the GST tax to the regular estate tax (yes, this is double taxation).
In 2010, the estate, gift, and GST tax exclusions were all set at $5 million, indexed for inflation. In 2017 the TCJA temporarily increased the exception from $5.5 million. The exemption is $12.06 in 2022 for unmarried persons and $24.12 million for married couples. The tax rate above that exclusion is 40 percent.
What's Your Estate Worth?
An estate tax calculation starts with your gross estate. The basic principle for valuing property is generally its fair market value, or "the price at which property would change hands between a willing buyer and a willing seller... both having reasonable knowledge of relevant facts." The date of valuation is either the date of death or six months later (whichever date is chosen, it applies to all property). (Note: Real estate used in a closely held business or farming operation may be valued with a “special use” method.)
Sometimes the fair market value of an asset is clear-cut, but often it is not. For example, valuing a closely held family business, an interest in a limited partnership, or even a thinly traded stock can be nuanced and may require the services of a professional appraiser.
The basic rule is that a federal estate tax return is due if the gross estate exceeds the applicable exclusion amount in the year of death ($12.06 million in 2022). Often it’s obvious that a particular estate will or won’t fall above this level, particularly with the exemption set so high. However, many other estates require close scrutiny.
WHAT’S INCLUDED IN AN ESTATE?
In a word, everything. Many assets are straightforward: for example, your investment accounts, bank accounts, residence, other real estate, equity in a business, cash value in an insurance policy, and personal property. However, other assets are a bit more obscure. For example, the following are also included in your estate:
- A life insurance policy that you own on the life of another person
- A life insurance policy on your own life if you own the policy or if you have an incident of ownership (the ability to exercise an economic right)
- A life insurance policy on your own life if you transferred ownership within the three years preceding your death
- Property held in joint tenancy
- Any property over which you have a power of appointment (the ability to name who will enjoy or own the property)
- The present value of a pension, retirement benefit, or annuity if there are survivorship benefits
- Any property in which you have a retained life interest (the ability to use the property under specified terms), even if you transferred the property to someone else prior to your death
- Any property that you revocably transferred prior to your death (you had maintained the right to take it back)
To value your estate, first add up your assets and subtract your debts. Then subtract the value of any assets that will be transferred to a charity on your death. If you’re married, you can also deduct the assets that will go to your spouse, provided he or she is a U.S. citizen (and therefore avoid estate tax until he or she dies).
SMART MOVE: You can avoid estate taxation of life insurance proceeds by creating an irrevocable life insurance trust (ILIT). The irrevocable trust is the owner and beneficiary of the policy. If there are no incidents of ownership retained by you, the proceeds are kept outside the estate. However, the trust must purchase the policy or the original owner must live at least three years after transferring an existing policy into the trust.
Married Couples Get a Break
It wasn’t very long ago that married couples had to set up bypass trusts (also known as AB trusts or credit shelter trusts) to take advantage of each other’s estate tax exclusions. This has changed because of portability, a relatively new provision that allows a surviving spouse to add any unused portion of a deceased spouse’s exclusion to her or his own exclusion. In other words, in 2022 a married couple can pass on up to $24.12 million to their heirs free from federal estate tax without a trust or any extra planning. The following example illustrates how portability works.
Husband and wife Braverman have two equal shares of an estate valued at $23.16 million. When Mr. Braverman dies, he leaves his entire $12.06 million to Mrs. Braverman. No estate tax is due because of the unlimited marital deduction. Mrs. Braverman’s estate is now worth $24.12 million. When she later dies, the first $12.06 million can pass to her heirs free of estate tax. However, her estate must pay tax on anything above $12.06 million, at a rate of 40 percent.
Under current law, the Bravermans can take advantage of each other’s exclusion. When Mr. Braverman dies, his executor can elect to transfer his unused $12.06 million exclusion to his wife. Like before, Mrs. Braverman’s estate is valued at $12.06 million, but she now also has a $12.06 million exclusion from taxes. She can pass on the entire estate free of tax.
With portability, the couple no longer has to use the decedent’s spouse “unused” exclusion amount. In other words, before portability it was a “use-it-or-lose-it” proposition. Portability extends the time to both spouse’s exclusion until the survivor dies.
CAUTION: Portability is not automatic. The executor must file an estate tax return even if no tax is due in order for the surviving spouse to take advantage of the deceased spouse’s exemption.
Note, though, that in our example we do not address potential appreciation. With traditional estate planning, the amount excluded from the first-to-die’s estate would be put into a bypass trust for the benefit of the surviving spouse. The assets in this trust, regardless of their value and any future appreciation, would then remain outside the surviving spouse’s estate for tax purposes. The trust could appreciate to any amount and still would be free of estate tax when the surviving spouse dies. Portability doesn’t allow for unlimited appreciation in this way. If you expect large growth and the potential to go over the exclusion, you might consider a bypass trust.
DIFFERENT RULES FOR A NONCITIZEN SPOUSE
The federal government doesn’t want someone who isn’t a U.S. citizen to inherit a large amount of money, pay no estate or gift tax, and then return to his or her native country. Therefore, if your spouse isn’t a U.S. citizen, you may not be able to transfer your assets to him or her tax-free.
Nonetheless, you can leave assets worth up to the exclusion ($12.06 million for deaths in 2022) to anyone, including your noncitizen spouse, without owing any federal estate tax. If the noncitizen spouse dies first, assets left to the spouse who is a U.S. citizen do qualify for the unlimited marital deduction.
If your estate exceeds this limit, you can also set up a qualified domestic trust (QDOT), which can postpone payment of estate taxes until after your noncitizen spouse dies.
CAUTION: As great as portability is for reducing or eliminating taxes, it does nothing to control how or when your heirs will receive assets. As a result, you may still want to discuss the benefits of a particular type of trust with your attorney. For example, in a second marriage a qualified terminable interest property (QTIP) trust can provide for the surviving spouse as well as for the children from a first marriage.
Strategies to Reduce Your Taxable Estate
Even with the generous exclusion, some estates may be subject to tax. You may want to discuss the following with your estate planner:
Gifting: Lifetime gifting has many advantages, not the least of which is the pleasure you can derive by seeing your beneficiaries enjoy your gift. In 2022 you can gift up to 16,000 to an unlimited number of people in a single year ($32,000 for a married couple “splitting gifts”) without triggering any tax. Not only do you remove the value of the gift from your estate, but you also transfer future appreciation to the beneficiary. This is one of the best ways to reduce your taxable estate at the same time that you help others.
CAUTION: The value of property gifted within the last three years of life may be included in your estate if it has “strings attached.” For example, if you gifted a second home to a relative but retained the right to use it as you please, the fair market value of the property could revert to your estate.
Before you gift highly appreciated property, also think about the potential capital gains tax for the beneficiary. If you transfer the property while you are alive, you also transfer your cost basis. But if you instead bequeath the property at your death, the asset’s cost basis will “step up” to the fair market value on the date of death. Let’s take a look at some numbers:
Let’s say you give your daughter $10,000 worth of stock that you purchased ten years ago for $2,000. If she sells the stock immediately, she will owe capital gains tax on the $8,000 profit. If your daughter instead receives the stock at your death when it is worth $10,000, she will have no tax for income tax purposes. Her tax basis would be $10,000—not $2,000.
- Making unlimited direct payments to qualified medical and educational institutions: Any payments that you send directly to an IRS qualified physician, hospital, or school or college on behalf of someone else aren’t counted in your annual gift tax exclusion. In other words, you can pay for your grandchild’s college education plus give them a gift of up to $16,000 a year without reducing your lifetime exclusion.
- Charitable giving: Bequests to a charity are fully deductible from estate taxes. One strategy is to transfer assets from your estate to a charitable lead trust (CLT). The charitable organization will receive an annuity for a set number of years, and at the end of the term your heirs will receive the remainder. You can also do the opposite with a charitable remainder trust (CRT). In this case, the trust will pay income for a period of time to beneficiaries you name. At the end of the stated period, the remaining trust assets pass to your charitable organization(s) of choice. You get a deduction for the portion of the value of the trust that is for the charity.
- Qualified personal residence trust (QPRT): You can transfer your home into a trust, thereby removing a portion of its value from your taxable estate. You retain the right to live in the house for a certain number of years, and at the end of that term the home is transferred to your beneficiary. You can then arrange to stay in the home and pay fair market rent. The longer the term, the smaller the gift for tax purposes. Once your home is placed in a QPRT, future appreciation accrues outside your estate. But beware that a QPRT will help avoid estate taxes only if you outlive its term of years. If you do not survive the QPRT term, the value of the residence is included in your estate.
Does Your State Have an Estate or an Inheritance Tax?
Most people focus on federal estate taxes. However, depending on where you live, you may also be liable for significant state taxes, which can take the form of either an estate or an inheritance tax (or in a couple of cases, both).
STATE ESTATE VS. INHERITANCE TAX
Estate taxes are based on the value of the deceased person’s estate no matter who receives it.
Inheritance taxes vary depending not only on the amount being transferred but also on the relationship between the deceased and the beneficiary. In most states, the closer the relationship, the lower the rate. A spouse will pay the least, a minor child will pay more, an adult child or parent will pay more still, and a brother or sister will pay even more. Nonrelatives will pay the most.
If you live in a state with an estate or an inheritance tax, you’ll need to do some extra planning. In most states the exclusion is well below the federal level of $12.06 million–plus. Also note that none of the states that have an independent estate tax have made the exclusion portable between spouses—so for some families a bypass trust could make sense.
A Word on the Generation-Skipping Transfer Tax
If you’re fortunate enough to have a large estate, and your children are also well-off, you may want to consider making gifts to your grandchildren, great-grandchildren, or unrelated people who are more than 37 ½ years your junior (yes, that’s the way the rules are written). Like other gifts, these will reduce your taxable estate. However, if the gifts don’t qualify for the $16,000 annual gift limit ($32,000 for a couple splitting gifts), they will be charged against your lifetime GST exclusion ($12.06 million in 2022) in addition to your lifetime gift tax exclusion. Any amounts over that will be taxed at 40 percent.
TALK TO AN EXPERT: No matter how you look at it, planning for an estate that is larger than the estate tax exclusion—or any complex estate—takes the expertise of an estate planning attorney. Review the basics for your own knowledge, then consult with an attorney you know and trust.
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