Plan for the Future

The Ins and Outs of Inheritance Tax, Gift Tax and Estate Tax

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Taxes are one of the largest potential expenses associated with your estate. Tax laws change often, so it’s best to consult with an attorney about your specific questions. But this general overview will help.

Estate taxes

Estate tax is the tax collected by the state or federal government when you transfer property at the time of your death. Two terms to keep in mind regarding estate taxes are your “gross estate” and your “taxable estate”:

Gross estate and taxable estate

Your gross estate includes the fair market value of all of your assets. For example, this could include cash and securities, real estate, insurance, trusts, annuities, business interests and other assets.

Certain deductions are allowed from your gross estate, such as mortgages and other debts, estate administration expenses, property that passes to surviving spouses and qualified charity. After subtracting these deductions from your gross estate, you’re left with a net taxable amount referred to as your taxable estate.

Federal and state estate taxes

There are separate federal and state estate taxes:

For federal estate tax purposes, your estate is exempt if its value is less than approximately $5.5 million – this amount increases every year to adjust for inflation, so be sure to check with a tax attorney or accountant for the exact amount if your taxable estate is close to this value. Married couples can combine their federal exemptions, doubling the total exemption amount. Because the federal estate tax exemption is so high, only about one percent of American estates have to pay estate taxes.

Amounts above the exemption rates are taxed at about 40%, although federal estate tax rates can vary. Gifts to your surviving spouse are generally exempt from federal estate taxes.

Federal estate taxes must be paid in cash, usually within nine months after you die. After the estate tax has been collected, the remainder of your estate can be distributed to your heirs.

Many states also collect estate taxes or inheritance taxes. In contrast to federal inheritance taxes that apply only to the richest Americans, state estate and inheritance taxes can apply to those with much smaller estates.

Currently, approximately half of the states have either an estate tax or inheritance tax. A couple states have both estate and inheritance taxes. State estate and inheritance taxes range from 16 to 20%. State exemption levels range from $675,000 (significantly lower than the federal exemption level) to $5.45 million (equal to the federal exemption level).

State estate taxes are generally charged against the estate regardless of who inherits it. In contrast, state inheritance taxes are generally applied differently depending on the person’s relationship to the deceased. All states exempt the surviving spouse from inheritance tax. Some states tax children of the deceased, but at a low rate. More distant relatives or people who aren’t related to the deceased are taxed at a higher rate.

As with federal estate taxes, state estate and inheritance taxes generally need to be paid within nine months. Because state inheritance and estate taxes vary so dramatically by your state of residence and can change often, talk to your financial advisor or attorney about any taxes in your state.

Gift taxes

In addition to estate and inheritance taxes that affect your estate after your death, if you give someone money or property during your lifetime, you may be subject to the federal gift tax.

The federal gift tax allows you to give away $14,000 each year to as many individuals as you’d like, without tax implications for either party. This is known as the “annual exclusion.” A married couple can give $14,000 each, for a total of $28,000 per recipient. If you give above that level, you’re likely subject to the federal gift tax rate.

In addition, payments made directly to educational or medical providers are tax-free and do not count against the $14,000 federal gift tax. If you want to fund your child or grandchild’s 529 college savings plan, you can put five years of gifts in the fund at once for a total of $70,000 – assuming no other gifts are made to that child during that time.

How to reduce estate taxes

There are many ways you can reduce or eliminate your estate taxes, such as:

  • Spend down your estate. The more you spend while you’re still living, the smaller your estate and the less likely you’ll have to pay estate taxes!
  • Give tax-free gifts as described in the “gift taxes” section above. This lowers the value of your overall estate, thereby reducing your estate sales tax bill, and gives you the added benefit of watching your loved ones enjoy some of their inheritance while you’re still living.
  • Give to a charitable trust. Charitable trusts allow you to make large gifts to tax-exempt charities, reducing the overall value of your estate.
  • Open a life insurance trust. A life insurance trust allows you to subtract the value of life insurance proceeds from your estate, and therefore from your estate-tax bill.
  • Consider state estate or inheritance tax rates when deciding where to live. If you have residences in two states, you may want to consider making your legal residence in a state without estate or inheritance taxes.

Where you can find estate tax help

To stay ahead of the latest federal estate tax and gift tax laws, visit the IRS website. An attorney who has experience with estate planning and tax laws can also help you make sure you are considering all the appropriate laws when creating or updating your plans.