What Exactly Is the Estate Tax?

Most people ignore the estate tax due to its high exemptions, but as some candidates may lower the exemption, it is good to familiarize yourself with it.

In the U.S., we treat the estate tax and gift tax as a single tax system with unified limits and tax rates—but it is not very well understood by many people.  Plus, the estate tax exemption is currently as high as it’s ever been, so many people ignore it assuming it doesn’t and never will apply to them.

However, the estate and gift tax has always been a political football, so it is a good idea to familiarize yourself with it in an election year.  The Motley Fool’s recent article entitled “What Is the Estate Tax in the United States?” gives us an overview of the U.S. estate and gift tax, including what assets are included, tax rates and exemptions in 2020.  As an overriding point, this blog covers federal estate and gift tax.  Some states have their own estate, gift and/or inheritance tax (tax on all transfers to beneficiaries at a lower rate) which may work differently then the federal tax.

The U.S. estate tax only impacts the wealthiest households. Let’s look at why that’s the case. Americans can exempt a certain amount of assets from their taxable estate—the lifetime exemption. This amount is modified every year to keep pace with inflation and according to policy modifications. This year, the lifetime exemption is $11.58 million per person. Therefore, if you’re married, you and your spouse can collectively exclude twice this amount from taxation ($23.16 million). To say it another way, if you’re single and die in 2020 with assets worth a total of $13 million, just $1.42 million of your estate would be taxable.

However, most Americans don’t have more than $11.58 million worth of assets when they pass away. This is why the tax only impacts the wealthiest households in the country. It is estimated that less than 0.1% of all estates are taxable. Therefore, 99.9% of us don’t owe any federal estate taxes whatsoever at death. You should also be aware that the lifetime exemption includes taxable gifts as well. If you give $1 million to your children, for example, that counts toward your lifetime exemption. As a result, the amount of assets that could be excluded from estate taxes would be then decreased by this amount at your death.

You don’t have to pay any estate or gift tax until after your death, or until you’ve used up your entire lifetime exemption. However, if you give any major gifts throughout the year, you might have to file a gift tax return with the IRS to monitor your giving. There’s also an annual gift exclusion that lets you give up to $15,000 in gifts each year without touching your lifetime exemption. There are two key points to remember:

  • The exclusion amount is per recipient. Therefore, you can give $15,000 to as many people as you want every year, and they don’t even need to be a relative; and
  • The exclusion is per donor. This means that you and your spouse (if applicable) can give $15,000 apiece to as many people as you want. If you give $30,000 to your child to help her buy their first home and you’re married, you can consider half of the gift from each spouse.

The annual gift exclusion might be an effective way for you to reduce or even eliminate estate tax liability. The tax rate is effectively 40% on all taxable estate assets.

It is also worth noting that a lot of clients want to give away assets during their life time through annual gift exclusions because they are worried about the estate tax.  However, with such a high exemption, it is often better to keep assets in your estate.  This is because generally appreciable assets in your estate receive a “step-up” in basis at your death.  This point is outside the scope of this blog, but see here for why keeping assets in your estate is probably a good thing.  https://www.galliganmanning.com/higher-estate-tax-exemption-means-you-could-save-income-taxes-by-updating-your-estate-plan/

Finally, the following kinds of assets aren’t considered part of your taxable estate:

  • Anything left to a surviving spouse, called “the unlimited marital deduction”;
  • Any amount of money or property you leave to a charity;
  • Gifts you’ve given that are less than the annual exclusion for the year in which they were given; and
  • Some types of trust assets.

Some candidates seeks to greatly lower the estate and gift tax exemption, which may lead to many more taxable estates.  If you are concerned about this tax, or are after the election, please contact our office to discuss how the estate and gift tax impacts you.

Reference: The Motley Fool (Jan. 25, 2020) “What Is the Estate Tax in the United States?”

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How Do Trusts Work in Your Estate Plan?
Trusts offer many benefits, so speak with your attorney on how to fit them in your estate plan.

How Do Trusts Work in Your Estate Plan?

Trusts offer many benefits including probate avoidance, tax and disability planning and protecting beneficiaries.
Trusts offer many benefits including probate avoidance, tax and disability planning and protecting beneficiaries.

Trusts can be useful tools for passing on assets, allowing them to be held by a responsible trustee for the benefit of the beneficiaries. However, determining which type of trust is best for each family’s situation and setting them up so they work with an estate plan can be complex. You’ll do better with the help of an estate planning attorney, says The Street in the article “How to Set Up a Trust Fund: What You Need to Know.”

There are lots of reasons to use trusts.  Many are used to avoid the time and difficulty involved with the probate process.  Others are used for estate tax planning and Medicaid planning.  Still others are used to pass financial assets to beneficiaries who might not be able to use them well or by themselves, such as with a disabled beneficiary, a beneficiary who wastes money or has creditors, or perhaps is struggling with addiction.  Many parents leave assets to their children in trusts so that the assets are excluded from their child’s potential divorce.  Trusts can even be used for your pets!  We have many blog posts on different reasons to use a trust, and here are a few:  https://www.galliganmanning.com/special-estate-planning-considerations-for-a-blended-family/ (blended families)  https://www.galliganmanning.com/do-you-need-a-pet-trust-in-your-estate-plan/ (pets) https://www.galliganmanning.com/some-common-estate-planning-mistakes-best-avoided/.    

If you are considering using a trust as part of your estate planning, you have to consider whether it will be revocable or irrevocable.  I’ll briefly describe both varieties.

Revocable Trusts are trusts that can be changed. They are often called Living Trusts.  This form of trust is typically used to avoid probate because assets properly owned or directed to the trust will not be probate assets.  Because of its flexibility, you can change beneficiaries, terminate it, or leave it as is. You have options, and it can change with you as your needs, wishes and plan change over time.  Once you die, the revocable trust becomes irrevocable and distributions and assets shift to the beneficiaries in the manner you chose. 

A revocable trust avoids probate for the assets it directs, but will be counted as part of your “estate” for estate tax purposes. They are includable in your estate, because you maintain control over them during your lifetime.  Under current law, very few people have an estate large enough to pay federal estate taxes, so having assets as part of your “estate” for estate tax purposes is actually a good thing.

Revocable Trusts are also used to help manage assets as you age, help you maintain control of assets if you don’t believe the trustees are ready to manage the funds, or to appoint other trustees in case you can no longer manage the assets yourself.

Irrevocable Trusts are called irrevocable because in theory you cannot change or revoke them.  However, most states have laws which permit revocation or change of irrevocable trusts in certain circumstances.  But, you should be careful about irrevocable trusts if you expect a need to change it in the future.

If estate taxes are a concern, it’s likely you’ll consider this type of trust. The assets are given to the trust, thus removing them from your taxable estate.  Irrevocable trusts of this type are less common than revocable trusts, but still can be a powerful weapon in your estate planning arsenal. 

These are just two of many different types of trusts. There are trusts set up for distributions to pay college expenses, providing for disabled individuals to preserve government benefits, charitable funds for philanthropic purposes, planning for pets after you are gone, leaving assets to a second spouse or children in a blended family and more.

Your estate planning attorney will be able to identify which types are most appropriate for your situation.  Here’s how to prepare for your meeting with an estate planning attorney when considering a trust:

Why do you want the Trust? Consider your goal.  Is it to avoid probate?  Is it for tax planning?  Is it because you know a beneficiary shouldn’t receive the assets but you still want to provide for them?

List beneficiaries. Include primary beneficiaries and have a plan for what happens when the primary beneficiary is deceased.

Map out the specifics. Who do you want to receive the assets? How much do you want to leave them? Why shouldn’t receive the assets immediately?  You should be as detailed as possible.

Choose a trustee. You’ll need to name someone who will respect your wishes, who understands your financial situation and who will be able to stand up to any beneficiaries who might not like how you’ve structured your plan. It can be a professional trustee as well.

Don’t forget to fund the it! This last step is very important. The trust does no good if it is not properly funded. You should speak with your estate planning attorney about how to fund the trust based upon the plan you selected.

Creating a trust can be a complex task. However, with the help of an experienced estate planning attorney, this strategy can yield a lifetime of benefits for you and your loved ones.

Reference: The Street (July 22, 2019) “How to Set Up a Trust Fund: What You Need to Know”

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Higher Estate Tax Exemption Means You Could Save Income Taxes by Updating Your Estate Plan

Updating your estate plan can save taxes.
Updating your estate plan could save taxes.

The estate tax exemption doubled as a result of the Federal Tax Cut and Jobs Act, raising it to historic highs. The estate tax exemption had been scheduled to increase to $5.6 million per person in 2018, but it was modified by the recent legislation to reach the current level of $11.2 million per person, or $22.4 million per couple. The inflation-adjusted exemption for 2019 is $11.4 million per person, or $22.8 million per couple.

In the article “Updating estate plan could save heirs in taxes,” the Atlanta Business Chronicle asks why this matters to an individual or couple whose net worth is nowhere near these levels.

When the most that could be transferred to a non-spouse beneficiary was under a million dollars, everyone worried about the estate tax and used trusts to minimize its effect. Since the estate tax was so much higher than the capital gains tax, it was never considered a big deal if a beneficiary paid the capital gains tax on selling trust assets, because it was less costly than paying the estate tax.

In the past, a married couple’s estate plan would often call for the deceased spouse’s assets to be placed in a trust for the surviving spouse (often called a “bypass trust”). The goal was for the trust to provide for the surviving spouse until the surviving spouse’s death, at which point the trust assets bypassed the estate of the surviving spouse and went directly to the beneficiaries, usually the spouses’ children. If the beneficiaries sold trust assets after the surviving spouse’s death, they would pay the income tax based on the value of the assets at the first spouse’s death, as oppposed to the value of the assets at the surviving spouse’s death. The higher the assets appreciated between the time of the first spouse’s death and the second spouse’s death, the higher the income tax.

For example, if a spouse owned $10,000 worth of stock which passed to a bypass trust at his or her death, and the stock increased to $100,000 at the death of the surviving spouse, the heirs would pay capital gains taxes on the amount of the appreciation ($90,000) upon the sale of the stock. If, however, instead of being in a bypass trust, the stock were included the surviving spouse’s estate, when the beneficiaries sold the stock, they would not have to pay capital gains taxes on the $90,000 of appreciation that occurred between the first spouse’s death and the surviving spouse’s death. That could be a substantial tax savings.

For those who included bypass trusts in their estate plans just to save on estate taxes, updating their estate plan to eliminate the bypass trust could bring greater simplicity as well as tax savings for the heirs.

It should be noted that the law creating the present $11.4 million estate tax exemption ends at the end of 2025, when the estate tax exemption will return to $5 million (adjusted for inflation). Because the tax laws are constantly changing, it is always a good idea to revisit your estate plan at least every three years. Learn more about what married couples should consider when updating their estate plan at https://www.galliganmanning.com/life-stages/planning-for-married-couples/

Reference: Atlanta Business Chronicle (May 31, 2019) “Updating estate plan could save heirs in taxes”

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