A Less Deadly Review of Estate Tax in the US
Careful planning includes learning what you need to know about an estate tax. If you don’t plan carefully then your beneficiaries may end up receiving a lot less than you had planned. When you think of an estate, you may be thinking about a mansion on a hill but you own an estate just because you own property. If you have property, whether it’s furniture, a car, home, or life insurance, you have an estate.
The estate tax rate can be one of the highest tax rates. It starts at 18% and can get as high as 40%. This means it’s important to carefully plan if you want to avoid the government getting the bulk of your hard earned assets.
It’s Not an Income Tax It’s a Transfer Tax
While it can be a little more complicated, the estate tax is a tax on property that is transferred to your heirs. When you pass, you have the right to transfer property, but it will cost you. At the time of your death, everything you own or have special interest in is accounted for and this includes everything from insurance and stocks to real estate and cash. The total of these things, which will be the fair market value and not what you think they are worth or what you paid for them, will be your “gross estate.”
Once the gross estate is calculated then it’s time to figure out the taxable estate. The taxable estate deducts items such as funeral expenses, qualified charities, estate administrator duties, and mortgages. The executor of the estate needs to file a federal estate tax return within nine months of the date of your death.
It Won’t Affect Every Estate
The estate tax only affects the wealthiest estates, which includes about two out of every 1,000 estates. For the tax year in 2019, the federal estate tax exemption is $11.4 million per person. If your property is less than this then you are able to transfer it to your heirs without being taxed. There are also ways to avoid paying the estate taxes.
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Why Planning Is Important
The estate tax can sneak up on you if you aren’t carefully planning for your estate with the right tax management. While the tax does only affect the wealthiest estates, even a middle-income taxpayer may not be out of the woods. Basic estate planning should happen, even if you only have assets of $750,000. There are three main reasons why estate planning is important and these reasons are value, exemption, and inflation.
Value
Many families can underestimate the value of their assets. For example, many people underestimate the value of life insurance policies. However, the face value of your life insurance policy can be a taxable component of an estate tax, even though proceeds are usually considered exempt from income taxes. While you can avoid paying estate taxes on most life insurance policies, there are some group policies, such as ones through work, that you aren’t allowed to transfer to avoid loopholes. There may be also other assets that you are underestimating that you need to address in order to avoid an estate tax.
Inflation
Estate plans should be looking 20 or 30 years into the future and more in some cases. Assets that are only worth $750,000 today can easily grow to the limits in 30 years.
Exemption
It’s possible that Congress can lower the exemption at any point if they choose. Anyone who is ignoring the estate taxes is then setting himself or herself up for problems. IRS tax rates can change whenever Congress wants to change them so it’s wise to be prepared. For example, at one point the estate tax was reduced and then completely eliminated in 2010, only to be brought back again a few years later.
With the right planning, you may be able to avoid the estate tax. Starting an estate plan in the last few years of your life won’t give you enough time to take advantage of the ways that you can transfer assets without others paying gift or estate taxes. Be sure to start early, even if you don’t think your assets are ever going to get to the limits.
State Estate Taxes
Many people just spend time focusing on the federal estate tax but depending on what state you live in, you may also have a state income tax, which can be significant. State estate taxes can take the form of an inheritance tax or an estate tax, or in some cases both.
There are some differences between an inheritance tax and an estate tax. Estate taxes are going to be based on the value of the deceased person’s estate, no mater who is getting the estate. Inheritance taxes vary depending on the amount being transferred, as well as the relationship between the beneficiary and the deceased. In many states, the closer the relationship then the lower the rate. A spouse will likely pay the least but a minor child will pay more and an adult child or parent will pay even more. A sister or brother is going to pay even more than a child. Non-relatives pay the most.
If you live in a state with an inheritance or estate tax then you will need to do some extra planning. In many states, the exclusion is going to be below the federal level. None of the states that have an independent estate tax have made the exclusion portable between spouses. For some families, a bypass trust may make more sense.
The highest top estate tax is in Washington - 20%
Estate Tax and Married Couples
At one point, married couples had to set up a bypass trust, known as credit shelter trusts or AB trusts, in order to take advantage of the tax exclusions. This has since changed due to portability. This new provision will allow the surviving spouse to use the unused portion of the deceased spouse exclusion to his or her own. This means a married couple is able to pass up to $23.15 million to heirs free from the estate tax without any extra planning or trust.
In order to understand how portability works, it helps to have an example.
Without Portability
Mr. and Mrs. Smith have two equal shares of an estate that is valued at $23.16 million. When Mrs. Smith dies, she leaves her entire share to Mr. Smith. There is no estate tax because of unlimited marital deduction. Mr. Smith now has an estate worth $23.16 million by himself. When he dies, the first $11.58 million can be passed to the heirs without estate taxes. However, the estate must then pay taxes above that $11 million at a high rate of 40%.
With Portability
With portability and under the current law, Mr. and Mrs. Smith can benefit from each other’s exclusion. If Mr. Smith dies then the executor can transfer his unused exclusion to Mrs. Smith. She is then able to pass on the entire estate free of taxes. With portability, Mr. and Mrs. Smith no longer have to use the spouse’s unused exclusion amount. Before portability, it was more of a use it or lose it proposition but portability extends the time of both spouse’s exclusion.
Portability will not be automatic. The executor will need to file an estate tax return, even if there isn’t any tax due, in order for the surviving spouse to take advantage of the exemption. In the example, potential appreciation isn’t addressed. With estate planning, the amount excluded from the first spouse to die’s estate would be put into a bypass trust for the surviving spouse. The assets in this trust, regardless of any appreciation and value, will then remain out of the surviving spouse’s estate for tax purposes. This trust may appreciate to any amount and still is free from estate tax when the surviving spouse dies. Portability won’t allow for unlimited appreciation in this way. If you do expect large growth and the potential to go over the exclusion then you may want to consider a bypass trust.
Portability is also useful to eliminate or reduce taxes but won’t do anything to control how or when the heirs actually get the assets. It may still be necessary to discuss different trust options with your attorney so you can provide for children from a first marriage or surviving spouse.
Exemptions
There are some exemptions. There are different uses for a non-citizen spouse. The federal government doesn’t want a non-U.S. citizen to inherit a large amount of money, pay no taxes on it, and then return back to his or her native country. If your spouse is not a U.S. citizen then you might not be able to transfer assets to him or her and have them be tax-free.
However, you could leave assets worth up to the exclusion to anyone, including a spouse that is not a citizen, without having to pay the federal estate tax. If your non-citizen spouse dies first then the assets that are left to the spouse that is a citizen will qualify for unlimited marital deduction. If your estate is going to exceed the limit then you can set up a qualified domestic trust. This trust can help postpone any payment of taxes until after your spouse dies.
Ways to Avoid an Estate Tax
If you have a large estate, you may be looking at ways that you can avoid the estate tax with taxes due in order to give your heirs more money. There are ways that it’s possible to help shield your estate with proper planning and knowledge of the loopholes.
Most states won’t tax Social Security at all. There are three states that do tax Social Security income in some way and some do provide a credit or limit to help offset the cost.
The way a state handles retirement accounts and pension income will also have a huge impact on your finances. There are 22 states that don’t provide any kind of exception, credit, or deduction on withdrawals from your retirement account. Exceptions for pensions are going to be more common to find. Only nine states will fully tax your government pension and 16 tax your income from a private employer pension. Other states will either exempt the income or give a credit or deduction against it.
Homeownership helps seniors lock in housing costs so they won’t have to worry about a shift in the rental market. However, some areas that have high property taxes or ones that grow quickly from one year to the next will discourage you from owning a home. States may help retirees limit the load of property taxes by giving circuit breakers or exemptions. These exemptions can help seniors protect part of the home value from property taxes. There are usually income limits so households that earn more than a certain amount won’t be eligible for these exceptions. Circuit breakers also have the same effect as exemptions. These can limit the amount of property taxes that can be increased from one year to the next.
Property tax deferrals can be helpful for homeowners as well. The deferrals will allow a senior to put off the payment of some or all of the taxes until a later time. These may be deferred so they are subtracted from the home sale and they don’t come out of a senior’s income.
It can be easy to overlook sales tax since it’s paid gradually. Sales tax is important to pay attention to since seniors are usually on a fixed income. There are four states that don’t have a sales or local tax. Hawaii has a similar tax to a sales tax but it’s one of the lowest in the U.S. Most states with a sales tax do provide exceptions that benefit seniors. Common exceptions are for prescription drugs, groceries, and medical equipment.
Legislators across the U.S. have started to either repeal their state’s estate tax or increase the local estate tax exemption. States are also following the federal government’s lead. Six states currently have an inheritance tax. Inheritance taxes will usually provide exceptions or lower rates for direct family members and then fully tax those who are non-relatives.
Legislators across the U.S. have started to either repeal their state’s estate tax or increase the local estate tax exemption. States are also following the federal government’s lead. Six states currently have an inheritance tax. Inheritance taxes will usually provide exceptions or lower rates for direct family members and then fully tax those who are non-relatives.
In Conclusion
While not everyone is going to have to deal with an estate tax, it’s something that requires some planning and thought. You are able to exclude a certain portion of your estate from the estate tax, but after that portion, you are taxed at a hefty amount. Planning is key, especially if you want to avoid an estate tax, and there are a number of ways to do so. Depending on where you live, it may not just be the federal estate tax you have to deal with but also a state one.