1. What are estate taxes?
Estate taxes are different from and in addition to probate expenses, which can be avoided with a revocable living trust, and final income taxes, which must be paid on income you receive in the year you die.
Federal estate taxes are expensive (historically, 35%-55%) and they must be paid in cash, usually within nine months after you die. Because few estates have the cash, it has often been necessary to liquidate assets to pay these taxes. But, if you plan ahead, you can reduce and even eliminate estate taxes.
2. Who has to pay estate taxes?
Your estate will have to pay federal estate taxes if its net value when you die is more than the exempt amount set by Congress at that time. The federal exemption was set at $5 million in 2011 and is adjusted annually for inflation; every dollar over the exempt amount is taxed at 40%.
3. How is the net value of my estate determined?
To determine the current net value, add your assets, then subtract your debts. Include your home, business interests, bank accounts, investments, personal property, IRAs, retirement plans and death benefits from your life insurance.
4. How can I reduce or eliminate my estate taxes?
In the simplest terms, there are three ways:
5. Use Both Exemptions
If your spouse is a U.S. citizen, you can leave him or her an unlimited amount when you die with no estate tax. But there can be problems when the second spouse dies.
For example, let's say Chris and Terry have a combined net estate of $10 million. When the Chris dies, everything is left to Terry, so no estate taxes are due at Chris' death. When Terry dies, the estate of $10 million uses Terry's $5 million exemption. This has been traditional planning for many married couples, but the problem is they waste Chris' exemption. With this approach, the tax bill on the remaining $5 million is a whopping $2 million!
Congress tried to fix this. Now, the executor of Chris' estate can transfer his unused exemption to Terry by filing a federal estate tax return at Chris' death. But if Terry remarries and outlives her new spouse, she would lose Chris' unused exemption. Also, by leaving everything to Terry, Chris has no control over how his share of the assets are managed or distributed. Plus, any growth on the assets will be included in Terry's estate and taxed when she dies.
If Bob and Sue plan ahead, they can use both exemptions and solve these problems. A tax-planning provision in their living trust splits their $10 million estate into two trusts of $5 million each. When Bob dies, his trust uses his $5 million exemption. When Sue dies, her trust uses her $5 million exemption. This reduces their taxable estate to $0, so the full $10 million can go to their loved ones.
This also lets Bob keep control over how his share of the estate is managed and distributed (important if he has children from a previous marriage). The assets are valued and taxed only at his death, so no growth is included in Sue's estate. And the assets in Bob's trust can be available for anything Sue needs.
Married couples with estates of all sizes find these benefits appealing. (This planning can also be done in a will, but you would not avoid probate or enjoy the other benefits of a living trust.)
6. Remove Assets From Your Estate
One way to reduce estate taxes is to reduce the size of your estate before you die. So go ahead and spend some, and enjoy it. Also, you probably know whom you want to have your assets after you die, so why not make some gifts now? It can be very satisfying to see the results of your gifts, something you can't do if you wait until you die.
Appreciating assets are best to give because any future appreciation will also be out of your estate. Gifted assets keep your cost basis (what you paid for them), so recipients may pay capital gains tax when they sell. But the top capital gain gains rate (20%) is still less than the estate tax rate (40%) that would apply if you hold onto the assets until your death.
Some popular strategies are introduced below. Note that these are irrevocable, so you can't change your mind later.
7. Tax-Free Gifts
Federal law now lets you give up to $14,000 ($28,000 if married) to as many people as you wish each year. So if you give $14,000 to each of your two children and five grandchildren, you will reduce your estate by $98,000 a year (7 x $14,000), $196,000 if your spouse joins you. (This amount is adjusted from time to time due to inflation.) State laws may differ.
If you give more than this, the excess will be considered a taxable gift and will be applied to your $5.25 million ($10.5+ million if married) "unified" gift and estate tax exemption. (If you use it while you are living, it's considered a gift tax exemption; if you use it after you die, it's an estate tax exemption.) Charitable gifts are still unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.
8. Buy Life Insurance
Depending on your age and health, buying life insurance can be an inexpensive way to replace an asset given to charity and/or to pay any remaining estate taxes. The three-year rule mentioned earlier does not apply to new policies. But you should not be the owner of the policy -- that would increase your taxable estate and estate taxes. To keep the death benefits out of your estate, set up an ILIT and have the trustee purchase the policy for you.
9. How To Reduce or Eliminate Estate Taxes Summary Chart
1. If Married, Use Both Exemptions
Living Trust with Tax Planning
• Uses both spouses' estate tax exemptions, doubling the amount protected from estate taxes and saving a substantial amount for your loved ones.
2. Remove Assets From Estate
Make Annual Tax-Free Gifts
• Simple, no-cost way to save estate taxes by reducing size of estate
• $14,000 ($28,000 if married) each year per recipient (amount tied to inflation)
• Unlimited gifts to charity and for medical/educational expenses paid to provider
Transfer Life Insurance Policies to Irrevocable Life Insurance Trust
• Removes death benefits of existing life insurance policies from estate
• Included in estate if you die within three years of transfer
Qualified Personal Residence Trust
• Removes home from estate at discounted value
• You can continue to live there
Grantor Retained Annuity Trust / Grantor Retained Unitrust
• Removes income-producing assets from estate at discounted value
• You can continue to receive income
Limited Liability Company / Family Limited Partnership
• Lets you start transferring assets to children now to reduce your taxable estate
• Often discounts value of business, farm, real estate or stock
• Can protect the assets from future lawsuits, creditors, spouses
• You keep control
Charitable Remainder Trust
• Converts appreciated asset into lifetime income with no capital gains tax
• Saves estate taxes (asset out of estate) and income taxes (charitable deduction)
• Charity receives trust assets after you die
Charitable Lead Trust
• Removes asset from your estate, saving estate taxes
• Income goes to charity for set time period, then trust assets go to loved ones
3. Buy Life Insurance
Through Irrevocable Life Insurance Trust
• Can be inexpensive way to pay estate taxes and/or replace charitable gifts
• Death benefits not included in your estate
Learn more about Advanced Planning Techniques