If you think that estate tax planning strategies are only for the nation’s one-percenters, think again. While it’s true that estates valued over $13.61 million for individuals and $27.22 million for married couples are currently subject to the federal estate tax[1]—which taxes the transfer of a person’s assets after they’ve passed—that does not mean you’re in the clear from other taxes that could ultimately impact your estate.
Whether you meet the threshold for the estate tax or not, it never hurts to plan for the future in order to preserve and protect what you wish to leave behind for others. Luckily, with help from your financial advisor, estate planning attorney, and CPA, you can ensure your ideal financial future plays out, as well as your financial legacy too. Let’s take a look at some of the many ways your estate can be taxed beyond “estate taxes,” and what can be done to ensure your assets are distributed the way you intended while minimizing significant taxes for those who inherit them.
[1] Sources: https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-estate-taxes | https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax | https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024
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Planning for All the Ways Your Estate Can Be Taxed
Income Taxes
When you leave assets to your beneficiaries, they typically qualify as additional income on the beneficiaries’ tax ledgers—and therefore are subject to all the incomes taxes and tax implications that come with it. Adding, for example, $100,000 to your daughter’s annual income could not only subject her to additional taxes owed but bump her up to a higher tax bracket and therefore a higher tax rate.
We see this all the time with tax-deferred vehicles like IRAs and 401k plans. They’re often the biggest asset people have—and the money has not yet been subjected to any taxation. Plus, under current tax law, non-spouse beneficiaries are typically required to take distributions on all inherited 401k and IRA assets within 10 years. If, hypothetically, you name your son as the beneficiary of a $5 million IRA, and he divides those distributions evenly across 10 years, he is adding $500,000 to his taxable income every year for a solid decade. Imagine the tax implications that could have.
State Inheritance Taxes
Even if you don’t meet the federal estate tax threshold, you may still be subject to state inheritance or estate taxes depending on where you live. Certain states have the ability to tax money and property inherited by your beneficiaries.
In Pennsylvania, for example, your beneficiary will have to pay the specific taxed percentage based on their relation to you, whether they are a direct descendant (someone directly down your family line, such as your children), a non-direct descendant (a niece, nephew, sibling, etc.), or someone who has no relation to you. Pennsylvania’s state inheritance tax rate is 4.5% for transfers to direct descendants, 12% for siblings, and 15% for transfers to other heirs[1].
Capital Gains Taxes
How you treat assets that are subject to capital gains taxes is another tricky piece of the estate planning puzzle. Let’s look at two scenarios.
In scenario one, you have an investment account that you started with $100,000 (your basis) that’s now worth $300,000. If you choose to leave this account via inheritance to your beneficiary as part of your estate when you pass, the IRS will grant your beneficiary a “step-up in basis” provision that honors the investment as a $300,000 starting value—meaning they don’t have to pay the capital gains tax on the $200,000 the account earned before you passed.
In scenario two, you instead choose to gift the account to your beneficiary before you pass away. As a result, your beneficiary assumes your original basis and does not get the benefit of the step-up in basis, and they will pay tax on any capital gains over the account’s original $100,000 starting value.
This type of occurrence is one reason why it’s critical to determine whether it’s best to give during your lifetime or leave your assets as part of your estate.
Understanding potential taxes on your estate helps you plan accordingly so that more money can be left to those who matter most to you instead of being taken by the federal and state government. Your financial advisor is here to help educate you on these possible implications and to determine the best ways to save and protect your assets based on what’s most important to you.
Key Planning Strategies for Actual Estate Taxes
But what if you do qualify for actual estate taxes? Are there other things you can do to minimize your unique tax burden? Here are some things to consider.
Utilizing Trusts as a Tool in Estate Planning
Some people believe that a trust can help them avoid the estate tax, but most trusts are not created for the purpose of saving taxes—and certainly not for avoiding them all together. Trusts mainly help you protect or control your assets after you are gone, but not all of them help you save on the federal estate tax. However, if you are someone who is over the federal estate tax threshold, or potentially could one day be, an Irrevocable Life Insurance Trust (ILIT) or a Qualified Personal Residence Trust (QPRT) could possibly make sense as one of the tools to utilize in your financial planning.
What do I need to know about an ILIT?
An ILIT allows you to put your life insurance policy within a trust so its proceeds are not viewed as part of your estate and therefore cannot be taxed when passed to your beneficiaries. With this type of trust, you are giving up ownership to a third party and it cannot be undone or changed once it is put into place—so consider this option carefully because it has the power to jeopardize your financial future if it’s not the right fit or it is not done properly.
What do I need to know about an QPRT?
A QPRT is another form of irrevocable trust that removes your residence from your estate in order to lessen the taxes on your estate once it passes to your beneficiaries. You can still live in your home during the trust’s term, but once it ends, the residence passes to your beneficiaries and the value is determined at the time of transfer and is reduced for estate tax purposes.
What do I need to know about transferring assets to an irrevocable trust?
So, we’ve discussed two (of many) forms of irrevocable trusts that could potentially be used to save on estate taxes by transferring your assets—such as your life insurance policy or your place of residence—to them. Other assets that will appreciate at high values over time can also be transferred into an irrevocable trust, but as always, we encourage you to discuss these options with your financial advisor before making any life-altering decisions.
Using the Marital Deduction to Your Benefit
Did you know there’s no limit on the marital deduction for estate tax? This means if you are married to a U.S. citizen you can transfer an unlimited amount of assets at any time to your spouse and they will be tax-free. While this could prove to be a good option for you now, keep in mind that if your spouse passes away after you, the estate tax liability then passes on to their beneficiary and it becomes their responsibility to pay the taxes on their estate—which includes what you transferred to your spouse.
Making Lifetime Gifts or Charitable Contributions
The lifetime gift tax exemption is an annually adjusted amount that the government allows you to give during your lifetime without having to pay the federal gift tax. As of 2024, the lifetime gift tax exemption is $13.61 million as an individual and $27.22 million for married couples[2]. In addition to the lifetime gift tax exemption, there is an annual gift tax exclusion that allows single parties to give up to $18,000 a year and married couples to give up to $36,000, in the form of assets or property, to an unlimited amount of people tax-free[3]. With this annual exclusion limit, you can reduce your taxable estate while being able to support the people that mean the most to you.
Contributions made to a qualified charitable organization can also provide an income tax deduction that helps to decrease your taxable estate. Another way to reduce your estate’s value while prioritizing giving is through a charitable trust. A charitable trust allows you to transfer your assets to any 501(c)(3) organization over an extended period of time, and it generates income tax benefits that can minimize the value of your taxable estate.
Estate Tax Planning Strategies Require Continual Monitoring
When planning for any type of tax on your estate, it’s vital to remember that this is an ongoing process, not a one-and-done occurrence. This is because tax laws are extremely complex and inevitably change over time.
For example, when the Tax Cuts and Jobs Act was passed in 2017, it took the federal estate tax exemptions and almost doubled them, making it so that only a very small percentage of people currently meet the threshold for paying federal estate taxes. However, that same legislation is scheduled to be sunset in 2025. If Congress does nothing, the lower, pre-2017 federal estate tax exemptions will be restored, pushing a significantly greater number of people into the estate tax “bracket” in 2026—and you could be one of them.
As you navigate this ongoing process, remember that having a skilled team of estate planning professionals can make a huge difference in your experience, so don’t hesitate to reach out to your financial advisor, estate planning attorney, and CPA for guidance and support. With their knowledge and skills, you can feel ready for whatever the future holds for you.
Advent Partners is here for you if you are interested in beginning your estate planning journey. Contact us today to discuss your unique situation and to learn more about our financial planning philosophy!
[1] Source: https://www.revenue.pa.gov/TaxTypes/InheritanceTax/Pages/default.aspx
[2] Source: https://smartasset.com/retirement/lifetime-gift-tax-exemption
[3] Sources: https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2024 | https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes
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