Estate taxes are one of the most controversial aspects of the U.S. tax code, often hotly debated during election time. The good news is that the vast majority of estates are not subject to the federal estate and gift tax, especially since smart estate tax planning can help you reduce or avoid paying federal estate taxes entirely.
The following is a brief overview of federal estate taxes, how they work, and how you can plan for them with a carefully designed estate plan.
What is estate tax?
Estate taxes are taxes imposed on the right to transfer property upon death. The federal unified gift and estate tax taxes property that is transferred from a decedent to his or her heirs.
How does the U.S. estate tax work?
Estates subject to estate tax must file a federal estate tax return with the IRS, and the highest current federal estate tax rate (2016) is 40%.
How do you know if an estate owes federal estate taxes?
A taxable estate is defined by federal law, and the most important provision is the personal estate tax exemption, which permits an individual to pass property with a value up to a certain dollar amount without any estate tax consequences, i.e., free of estate tax. The amount changes slightly each year, but because it is currently at $5.45 million for deaths in 2016, few estates—around 1%—are affected.
Note that gifts made during your lifetime also count toward this number. If a gift is taxable—gifts to spouses, for example, are not—the giver is responsible for paying any taxes owed. However, since the threshold for cumulative gifts given within a lifetime is so high (again, $5.45 million for deaths in 2016), it is rare that any gift taxes are owed. The annual gift exclusion is $14,000 as of 2016.
In addition to the personal estate tax exemption, the marital deduction allows a property to pass from one spouse to the other without any estate taxes.
Moreover, a surviving spouse can use the remainder of the decedent spouse's exemption, giving married couples an exemption of twice the individual exemption amount (i.e., $10.9 million for deaths in 2016).
Property left to a tax-exempt charity also escapes federal estate tax.
Estate tax information for 2016 is available in a PDF available on the IRS website.
What about inheritance taxes?
Another consideration regarding estate taxes is inheritance taxes, which are imposed on the receipt of property from a deceased person. Inheritance taxes are the responsibility of the receiver of the property, not the estate.
The federal government does not apply an inheritance tax, and only a handful of states apply one, but it is important to note that you do not have to be a resident of one of those states in order to be taxed. The tax may apply if the decedent lived or owned property in one of the states that collects inheritance taxes.
Is avoiding estate taxes possible?
If you believe your estate may be subject to estate taxes, you can plan to reduce estate taxes in several ways, including the following:
- Make tax-free gifts during your lifetime. Gifts to a tax-exempt charity or directly paying someone else's college tuition or medical bills are two examples of tax-free gifts.
- Create an AB trust. The most common type of trust used to avoid estate taxes is an AB trust, through which spouses leave their property in trust for their children but for use of the surviving spouse for life.
- Create a charitable or life insurance trust. A charitable trust makes a substantial gift to a tax-exempt charity while a life insurance trust puts life insurance proceeds outside of the estate, excluding their value from the total that would be subject to estate taxes.
Do you need professional estate planning advice?
The laws concerning estate taxes change frequently, even from one year to the next, so that alone is a good reason to seek out professional advice regarding your estate.
So, yes, if you are concerned about your estate being subject to taxes, it is imperative that you consult an experienced estate planning attorney to discuss your options in order to minimize the impact of estate taxes.
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