If you want to be sure that you're able to pass on the bulk of your assets to your spouse or children, it's essential that you fully understand how estate taxes, both at the federal and state levels, may affect your plans. While the rules may seem complex, there are several useful strategies that can be used to minimize taxes on your estate — or eliminate them altogether.
What is the Federal Estate Tax?
The federal estate tax is an excise tax imposed on the transfer of your assets at death. It's based on your "gross estate," that is, the fair market value of all the assets held in your name, including real estate, stocks, bonds, cash, life insurance, retirement benefits, business interests and other property.
Most estates aren't affected by the tax, thanks to an exemption written into the tax law. In 2017, estates with a value of $5.49 million or less do not have to pay the federal estate tax. The exemption amount is adjusted annually to compensate for inflation. If the value of your estate exceeds the exemption amount, however, your assets (minus the amount covered by the exemption) will be subject to a flat 40% tax. This tax must be paid by your estate within nine months of your death.
This exemption amount also pertains to two other federal taxes: the gift tax, which is levied on wealth you transfer during your lifetime, and the generation-skipping tax on transfers to grandchildren or great-grandchildren. Using the exemption to lower gift or generation-skipping taxes reduces the size of the exemption that you can apply to your estate when you pass away.
State Estate & Inheritance Taxes
Some states impose their own version of the estate tax, an inheritance tax, or both. Rates vary from state to state. Inheritance taxes are different from estate taxes in that they are not levied on your estate at death. Instead, each of your beneficiaries must separately pay an inheritance tax based on a percentage of the value of the property you leave them, above the exemption level.
Reducing Your Estate Tax Bill with Deductions
Two major deductions can reduce or eliminate your estate tax: the marital deduction and the charitable deduction. Your estate can also deduct certain expenses, such as professional fees and administrative costs, from the assets used to figure your tax bill.
The Marital Deduction
The law gives you an unlimited deduction for whatever assets you leave to your spouse, as long as he or she is a U.S. citizen. Taxes on your estate are deferred until your spouse passes away. It's possible to avoid federal estate taxes completely by leaving your entire estate to your spouse, if you so desire.
The marital deduction has several advantages:
A larger nest egg. Avoiding the estate tax gives your spouse more money to invest or put toward living expenses.
Hard-to-sell assets can be kept. If the estate tax bill is large, your spouse could be forced to sell assets to pay it. That can be a real problem with illiquid assets like businesses, farms, real estate or art. The marital deduction makes such sales unnecessary.
More opportunity for distributing your assets. The IRS allows individuals to make tax-free gifts of up to $14,000 (as of 2016) each year to whomever they wish. Since the marital deduction keeps your estate intact, your spouse has more resources to give out as gifts after you're gone.
You can't use the marital deduction if your spouse is not a U.S. citizen. However, there is an alternative that allows you to leave your estate to your spouse without paying the estate tax: a qualified domestic trust. If you set up a qualified domestic trust, the estate tax won't be owed until your non-citizen spouse dies or withdraws assets from it. For more on this, read part one of our series on wealth planning for multinational families.
The Charitable Deduction
Like the marital deduction, the charitable deduction is unlimited. Donations that your estate makes to charity are subtracted from the value of your assets. Unlike the marital deduction, the charitable deduction doesn't merely postpone tax liability — it reduces it permanently. That creates a strong incentive to leave part of your estate to causes that you care about.
Portability: Passing on Your Exemption
The $5.49 million combined exemption from federal estate and gift taxes is considered "portable." In other words, if you fail to use the entire exemption, your executor can transfer any unused amount to your spouse on your death. Your spouse can then apply this remaining exemption to his or her own estate tax bill.
This is a recent change. Before 2011, any part of the exemption that was not used was lost. Be aware, though, that the generation-skipping tax exemption does not have this portability feature. Your spouse can't apply your unused exemption to this tax. In addition, exemptions for state estate taxes are generally not portable.
Portability was designed to simplify estate planning for smaller estates, but it has made the estate planning process more complicated. It's up to you to determine whether relying on portability or creating a trust is the best way to minimize the estate tax burden. Seek professional advice on the best tax strategy for your estate.
Next: Using Trusts to Transfer Assets
For wealthy individuals interested in leaving a legacy for their families, the estate tax can be a challenging hurdle. But it's possible to minimize or entirely avoid the impact of the tax with smart planning and an efficient use of the available deductions. Beyond that, there are also several kinds of trusts that can be used to transfer assets tax free. These methods also often have the advantage of allowing you to avoid probate. In the next part of the estate planning series, we'll take a closer look at these trusts, and how you can best use them to achieve your wealth transfer goals.