Updated: Jan 28, 2021
Here I am with the second part of estate planning: determining the tax consequences associated with your net worth.
About 4,100 estate tax returns will be filed for the people who die in 2020, of which only about 1,900 will be taxable – less than 0.1 percent of the 2.8 million people expected to die in that year; see Taxpolicycenter.org website. The question becomes at what net worth number do you need to start planning on strategies to reduce or eliminate your estate tax liability.
Only six states have an inheritance tax: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. While New York does not have an inheritance tax, it does have an estate tax. This means that if someone leaves you an inheritance in those states, you will need to pay an additional tax in those states. Because there is a variability to state inheritances, and because we are located in a state that has no inheritance taxes, we will only discuss the three basic federal taxes involved with estate planning: (i) estate tax; (ii) gift tax; and (iii) generation-skipping transfer tax.
The Federal Estate tax is a tax on your right to transfer property at your death; see IRS.gov. Currently there is an $11,580,000 exemption for the federal estate tax. That means, if your estate is under the $11,580,000, your estate will not have to pay a federal estate tax. It’s similar to the standard deduction associated with your federal tax forms. However, if your estate is over $11,580,000, you will have to pay federal estate taxes on the remainder.
Keep in mind that if you are married, any assets left to your spouse would not be subject to the federal estate tax at the time of your death, because there is an unlimited marital deduction. The federal government is waiting until you have both died and then will assess the federal estate tax. What does that mean to you, it means that if you die, and then your spouse dies, your estates could have a federal estate exemption of $23,160,000. Again, I say could, because as we all know Congress can and does make changes to the laws. As of 2020, if you and your spouse die, your estates federal estate tax exemption would be $23,160,000. Again, should your estate exceed the $23,160,000, you would be taxed on the estate over that exemption amount.
For example, let us say my net worth is $40,000,000. I die and leave everything to my husband, Cory. Because there is the unlimited marital deduction, Cory would receive all of the $40,000,000 with no tax consequences. However, when he dies and leaves the $40,000,000 to his children, his children would have to pay federal estates taxes. The children would be able to exempt the $23,160,000 from the $40,000,000, leaving a taxable estate of $16,840,000. Using the 2020 tax bracket, the children will be taxed $345,800 on the first million and then 40% on the remaining $15,840,000, which is $6,336,000. Therefore, the children would have to pay $6,681,800 in federal estate taxes on my $40,000,000 net worth. This total is the 40% of $15,840,000 plus the $345,800. Food for thought: Depending on how much money gifting you did in your life, might lower the federal estate tax exemption. This is discussed more fully below. Also, please note, I do not have $40,000,000.
The point of this exercise is to state that the federal estate tax exemption for a married couple is $23,160,000, which may be one of the reasons that only 0.1% will pay federal estate tax.
Gift Tax is a tax on the transfer of property by one individual to another while receiving nothing, or less than full value, in return. The gift tax applies to the transfer by gift of any property; see IRS.gov. It can be a physical gift, a conveyance of property for less than market value; or paying off someone’s debt. As of 2019, the federal gift tax exemption is currently $15,000 per person per year. That means you can give $15,000 to as many people as you want in a year with no tax consequences.
However, there is one caveat, you cannot give away more than $11,580,000 in cash or other assets during your lifetime. If you do, then you will be responsible for paying a federal gift tax and your federal estate tax exemption will also decrease. Two important facts of the federal gift tax: (i) the gift giver pays the federal gift tax; and (ii) as of 2020, the gift giver will not owe the federal gift tax until they have given away more than $11,580,000 in cash or other assets during their lifetime. I can give $30,000 to each of my six step-children this year and not have to pay the federal gift tax on the gift because I have not given away $11,580,000 in my lifetime. However, it is a rolling total, so if I do go above that $11,580,000 during my lifetime, it will be deducted from my federal estate tax. In simple terms the gift tax and the estate tax are united.
There are some exemptions to the gift tax. If you give a gift to (a) an IRS-approved charity, (b) to your spouse; (c) cover another person’s medical expenses (paid directly to the medical service provider); and (d) cover another person’s tuition expenses (again paid directly to the educational institution; payment for room and board, books and supplies are not considered exempt). Again, more than likely, you will never have to worry about this gift tax. But since it’s my job to inform you, I need to mention it.
Generation-Skipping Transfer Tax. This is when you directly skip one or more generations by transfer money or property to either your grandchildren, skipping their parents; or to someone who is at least 37 ½ years younger than you. By instating this tax, it closed the loophole of the wealthy individuals gifting money and property to their grandchildren without paying the federal estate tax. The Generation-Skipping Transfer Tax is a flat rate of 40% and has the $11,580,000 threshold. So, again, informational, but probably not applicable to your situation.
Remember, this blog covers only the bare basics of estate planning taxes and addresses the exemptions as of 2020. The exemptions are based on the Tax Cuts and Jobs Act effective 2018. The Tax Cuts and Jobs Act is expected to expire at the end of 2025. If you want more details regarding taxes, feel free to contact me, Debie Stewart, at 646.592.5311 and we can walk through the IRS Publication 950: Introduction to Estate and Gift Taxes and Form 709 together.