Tax Implications of Estate Planning

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The last thing most people think of (or maybe not at all) when creating or updating their estate plan is how federal or state taxes could impact them or beneficiaries of their estate. Understanding the various taxes now could minimize consequences later. Here’s a breakdown of the tax implications of estate planning.

Taxes and Estate Planning

There are several taxes that can affect your estate, heirs, loved ones, and estate plan

Estate Tax

The federal estate tax is imposed on the value of your estate when assets are transferred to beneficiaries upon your passing. It’s a tax your estate would have to pay that is due nine months after you die. But don’t panic! These taxes only impact the wealthy and those with high value estates, and most Americans won’t need to worry.

Under the 2017 Tax Cuts and Jobs Act, the exemption was raised for both estate taxes and gift taxes. As of 2021, estates valued at $11.7 million or more – including taxable gifts – are affected. If the estate is valued under $11.7 million, it is exempt from the estate tax, meaning that if you individually own less than $11.7 million, you do not need to worry about federal estate taxes.

However, this exemption expires in 2025. Beginning January 1, 2026, the exemption returns to the initial – and much lower – $5.49 million, which is adjusted for inflation. So, if the estate’s value is $5.49 million or higher, the estate tax kicks in. 

In addition to the federal estate tax, a state estate tax may also have to be paid – creating a double whammy. There are several states that have an estate tax: Connecticut, Massachusetts, Maine, Rhode Island, Vermont, Oregon, Washington, Minnesota, Illinois, Maryland, New York, Hawaii and Washington, D.C. 

The limits vary state-to-state, ranging from $1 million in Massachusetts and Oregon to $5.74 million in New York. Estates worth at and above these limits are subject to the state estate tax.

The tax is based on the total current fair market value of an estate’s assets – property, cash, investments, and other assets – on the date of the decedent’s death. This means the value isn’t necessarily what they were worth when you acquired them. Say you bought your house for $100,000 decades ago that is now worth $400,000. The latter is the fair market value.

Related: How to Update Your Estate Plan When You Buy a Home

There are deductions allowed before arriving at the taxable estate value. Property transferring to a surviving spouse or charity, such debts as mortgages, and estate administration expenses can be deducted. Also, the unified tax credit (a combination of the gift and estate tax exemption) can be applied to reduce the estate tax.

State Inheritance Tax

There are six states that impose an inheritance tax: Kentucky, Maryland, New Jersey, Iowa, Pennsylvania, and Nebraska. This tax is paid by heirs and beneficiaries when they inherit assets. 

The inheritance tax differs from the estate tax. Where the estate tax is based on the value of the assets before they are transferred, the inheritance tax is determined by the beneficiary’s relationship to the decedent and exemptions.

Most states base the tax on a sliding scale ranging from as low as 1% up to18% of the inheritance. Exemptions range from up to $500 to as high as $25,000.

Immediate family – including surviving spouses, children, siblings, and charities – are generally exempt from the inheritance tax. 

Maryland is the only state that has both an inheritance tax and a state estate tax.

Gift Taxes

Gifting is a way to reduce your estate’s value and avoid an estate tax.

You are allowed to gift any person or charity up to $15,000 each a year and not be taxed. If you’re splitting the gift to a person or entity with your spouse, the tax-free limit is $30,000. Recipients do not have to report the gift.

If you give more than $15,000 or are splitting the gift with your spouse, then you must file IRS Form 709 and report the amount. 

You and your spouse are both allowed a lifetime gift exemption of up to $11.7 million. As with the estate tax exemption, this amount will revert to its original amount in 2026. For the lifetime gift tax exemption, that amount will be $6 million. 

Once you exceed the annual gift tax exclusion, you begin to chip away your lifetime gift and estate tax exemption. Let’s look at this scenario. Say you gave a family member a $215,000 gift. Since the first $15,000 doesn’t count, the $200,000 remaining is deducted from your lifetime exemption, leaving $11.5 million.

Related: Estate Planning and Charitable Donations

Generation-Skipping Transfer Tax

This tax is imposed when assets valued at more than $11.7 million are transferred to someone who is at least 37 ½  years younger than you or to a relative who is two or more generations below your generation, such as a grandchild or great grandchild. The recipient is responsible for paying the tax.

The idea behind the Generation-Skipping Transfer Tax was to close a loophole typically used by wealthy families to transfer assets from a Trust to grandchildren to avoid paying estate taxes. A spouse is exempt from this tax.

Capital Gains Tax

This is a tax on any profit made from an investment, such as selling stocks or property. There are short-term and long-term capital gains. Short-term is an investment held for less than one year and is taxed at a higher rate than long-term capital gains. The amount owed on the tax can be reduced by any losses incurred.

Step-Up Basis

While this is not a tax, it can affect the amount of capital gains tax you or a beneficiary might owe on the change in value of an asset that is inherited. For example, you buy a stock at $10 a share. Years later, you bequeath that stock now worth $20 a share to your son or daughter. The tax would be on the $10 increase, not the actual value of the stock. The stepped-up basis helps reduce capital gains taxes.

Income Taxes

Any income generated while settling an estate or Trust must be reported on IRS Form 1041, Income Tax Return for Estates and Trusts. It is the responsibility of the estate’s executor to file and pay any taxes on the decedent’s estate by April 15th the year after the owner’s death. Any income the decedent received prior to passing such as wages, interest, or profits from selling investments must be reported.

Minimize Tax Implications with Estate Planning

A carefully crafted estate plan can help minimize taxes you or beneficiaries might owe. A Will and a Trust should be in your arsenal.

Related: Comparing a Will-Based Estate Plan and a Revocable Living Trust-Based Estate Plan

Living Trust

A Trust can help save both you and beneficiaries from paying an estate tax if your estate is or will be above the threshold. Remember, in 2026, the estate tax and lifetime gift tax exemptions drop from the current $11.7 million to $5.49 million and $6 million respectively.

Let’s say you want to leave your assets to your daughter. When you place assets in a Trust, you – your estate – no longer owns or controls it. The Trust owns it. When you die, the assets pass directly to your daughter without going through probate. While the assets are in the Trust, they can grow in value. While interest earned is taxable, distributions from the principal are not. 

You can provide specific instructions in the Trust as to how and when the assets are to be distributed. If the beneficiary is a young son or daughter, you can instruct that they are to receive the assets when they reach a certain age or graduate from college. You can set limits as to how much or little and how often distributions are to be made. 

A Trust may help maximize your gifting when it comes to taxes. There are tax savings opportunities and implications depending on the type of asset you want to donate. For instance, a gift to a beneficiary that would be taxable could be tax exempt when donated to a charity.

Last Will and Testament

This document allows you to bequeath assets – cash, property, or securities – to individuals or charities. You can split the gifts between your beneficiaries and charities or set percentages of remaining assets to be distributed to your favorite charities once your beneficiaries receive their inheritances.

Since bequests to charities can be deducted from your estate’s value, it can be a great tax advantage. Something to consider since the federal estate tax and lifetime gift exemptions will be decreasing.

Even if you’re not subject to estate taxes, you still need a Will. If you die without a Will, the state will take control of your estate and distribute the assets under the intestacy law. This can lead to loved ones arguing over who should get what and lead to an expensive and drawn-out legal battle.

Let Gentreo Help You Get Started

In addition to helping you create an estate plan tailored to your situation, Gentreo now offers one-to-one onboarding and consultations with our coaches, connections to licensed attorneys in all fifty states, a tool to create legacy messages for loved ones, funeral planning resources, and more. Don’t burden your loved ones! At a minimum, create a Health Care Proxy, Power of Attorney and a Will, and store and share them in your Gentreo Digital Vault. Taking this simple action is worth its weight in gold for you and your loved ones. 

Most Americans do not really need to be concerned about taxes, but we all need these three documents. What’s more, these documents are much more useful and valuable when they’re stored digitally, so you can share them with your loved ones and everyone knows where to turn if something happens.

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