Federal "Death Taxes" FAQ
When making an estate plan, many people wonder whether their estate will have to pay so-called “death taxes." Though the Internal Revenue Service (IRS) does not collect an inheritance tax, large estates must often pay a federal estate tax upon the owner's death. Additionally, the federal government imposes a gift tax and a generation-skipping transfer tax.
This article discusses all three federal taxes. It then concludes with a brief discussion of state-level death taxes.
Will My Estate Owe Federal Taxes When I Die?
The federal government imposes an estate tax, gift tax, and generation-skipping transfer tax. The governing tax law can be found in the Internal Revenue Code, Subtitle B, Chapters 11-13. This section discusses each tax in turn.
Chapter 11, Estate Tax
When someone dies, their estate may be required to pay a federal estate tax. However, because the estate tax exemption is currently set at over $12 million, most people need not worry.
That said, if the value of your estate exceeds the current exemption, it may face a tax rate between 18-40%. Notably, the unlimited marital deduction allows you to avoid the tax by leaving your entire estate to your spouse when you die, but only if they are a U.S. citizen.
Note: To see how the federal estate tax exemption changes from year to year, see Table A at the end of this article.
Chapter 12, Gift Tax
According to the IRS, “any gift is a taxable gift." However, the federal gift tax comes with many exemptions. For example, medical expenses, tuition, and gifts to your spouse are excluded.
Further, the annual gift tax exclusion also allows you to make gifts under a certain “fair market value" to as many people as you want each calendar year. Finally, the current “basic exclusion amount" (BEA) temporarily allows you to give over $11 million in tax-free lifetime gifts.
Note: To see how the federal annual gift-tax exclusion changes from year to year, see Table B at the end of this article.
Chapter 13, Tax on Generation-Skipping Transfers
Also known as the GSTT, this tax applies to gifts or inheritances left to someone who is at least 37.5 years younger than the original owner. Before this tax was introduced in 1976, older generations were able to avoid taxes by “skipping" a generation.
Though a deep dive into this area of tax law is beyond the scope of this article, the GSTT is designed to eliminate the following scenario:
Imagine a wealthy individual who does not qualify for the federal estate tax exemption. Because they are disqualified, they pay their estate tax before leaving a large amount of money to their child. If the child is also disqualified, they will pay the estate tax again when they die.
To avoid “double taxation," an older individual (e.g., a benevolent grandparent) could instead leave money through a gift, inheritance, or trust fund to someone other than their child. For example, if they left the funds to a beloved grandchild instead of the child's parent, the grandparent could eliminate a rung in the generational tax.
How Can a Trust Reduce My Estate Tax?
Trusts are a common way of reducing or eliminating both estate and gift taxes. A trust is a property arrangement in which a grantor transfers assets to be managed by a trustee for the benefit of a beneficiary.
Though there are many kinds of trusts, they all transfer ownership of the assets from the grantor to the trust itself. Because the grantor and the beneficiary do not themselves own the assets, they can avoid or reduce taxes. Below are four kinds of trusts that may be used for this purpose.
1. A-B Trust
Also known as a “bypass" trust, an A-B trust actually involves two trusts (the “A" and “B"). Upon the death of a spouse, the “decedent's trust" (B) is funded with an amount up to that tax year's estate tax exemption and the “survivor's trust" (A) is funded with the remainder of the married couple's assets.
The unlimited marital tax exemption ensures that the A-trust assets are only taxed when the survivor dies. The survivor receives income from the B-trust as a beneficiary during their lifetime, after which the next beneficiaries in line (normally the couple's children) reap the fruits.
2. Qualified Terminable Interest Property (QTIP) Trust
A QTIP trust also allows a deceased person to ensure that their surviving spouse receives trust income as a beneficiary. At the same time, the decedent controls who receives the assets when the survivor dies.
For example, they can name children from a previous marriage as residual beneficiaries. Again, the unlimited marital exemption ensures that assets are only taxed upon the surviving spouse's death.
3. Charitable Remainder Trust (CRT)
By giving large assets (e.g., a highly appreciated real estate investment) to a tax-exempt charity, you remove the asset from your estate and thereby avoid the estate tax. If the charity then sells the asset and reinvests the proceeds, it will also avoid the capital gains tax.
Although you relinquish control of the asset, you can receive lifetime income from trust investments by naming yourself as a lifetime beneficiary. The “remainder" when you die goes to the charity.
4. Life Insurance Trust
This kind of arrangement transfers your life insurance policy out of your taxable estate and into the trust. The life insurance proceeds generated when you die are also kept out of your estate.
Although you relinquish control of the trust once it is made, you can name beneficiaries and specify how the assets should be handled within the trust formation document.
Can I Still Control Trust Funds Used for Tax Purposes?
Note that trusts used for tax purposes must generally be “irrevocable," meaning that the trust terms cannot be changed once they go into effect. This ensures that the assets are truly and meaningfully removed from the grantor's estate because the grantor fully relinquished control.
Because they cannot be changed, irrevocable trusts should be created with caution. A tax professional and estate planning attorney can help you understand the pros and cons of using a trust for tax purposes.
Do States Impose “Death Taxes"?
Yes, a minority of states tax estates, inheritances, and gifts. In some cases, the same tools used to reduce federal taxes may be used to reduce state taxes. However, this depends greatly on the specifics of your state's laws. Each kind of state-level tax is discussed in turn below.
1. State Estate Taxes
By 2005, the Federal Tax Act of 2001 completely phased out what were known as “sponge taxes" or “pick-up taxes." Although these taxes did not raise the total amount owed by individual taxpayers, the old system allowed states to skim a portion of federal estate taxes for themselves. The difference appeared as a tax credit against the federal tax.
When this system was eliminated, some states began taxing estates directly. Currently, twelve states (plus the District of Columbia) impose an estate tax: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont and Washington.
Exemption amounts vary from state to state. So even if your estate does not owe the IRS money, it may still be required to pay a state estate tax.
2. State Inheritance Taxes
Unlike the federal government, some states also impose an inheritance tax. Where estate taxes are paid by your estate when you die, inheritance taxes are paid by individuals when they receive distributions from your estate as an inheritance.
Currently, six states impose an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. Again, exclusion amounts vary from state to state.
3. State Gift Taxes
Finally, Connecticut is the only state that imposes a gift tax. According to a Connecticut state website, “[A]ll transfers of real or personal property by gift . . . are subject to tax if the fair market value of the property exceeds the amount received for the property."
An Attorney Can Help
At the end of the day, most people do not need to worry about death taxes. However, if you are interested in preserving the value of your estate by reducing its tax liability, an estate planning attorney can help you maximize advantages and ensure that you comply with governing tax laws. Contact a local estate planning attorney to learn more.
Table A: Federal Estate Tax Exemption by Year
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