Estate Tax Planning: How Does Your Strategy Look?

When it comes to transferring wealth, estate planning and tax planning go hand in hand.
Tiffany Lam-Balfour
By Tiffany Lam-Balfour 
Edited by Chris Hutchison

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You’ve accumulated assets during your lifetime and may want to transfer wealth to your heirs or a favorite charity. As you make estate planning arrangements, don’t forget that estate taxes may come into play, potentially reducing the size of your estate or disrupting your aspirations.

Being diligent about estate tax planning can help manage your future tax liability and maximize the legacy you leave behind.

How taxes have an impact on estate planning

When it comes to estate planning, taxes matter because not only are there several types of taxes to be aware of — more below — but they can also be hefty.

On the high end, federal estate taxes can reach 40%. This means that if you have $1 million over and above the estate tax exemption, you would hand $400,000 over to the IRS and leave $600,000 behind to give away. And that’s not even accounting for any state tax liability.

Federal estate tax exemption & Biden's estate tax plan

Each individual has a lifetime estate or gift tax exemption, sometimes referred to as a basic exclusion amount or unified tax credit. This exemption designates the amount of assets you can give away, either over the course of your life or after your death, without being subject to federal estate or gift taxes. For 2021, the federal estate tax exemption was $11.7 million per person; in 2022, it is $12.06 million. Married couples can double that amount.

President Joe Biden pledged during the 2020 campaign to reduce the estate tax exemption. This proposed change is being considered along with other tax revisions, such as increasing capital gains tax rates. That said, the estate tax exemption level is scheduled to revert to historical levels of about $5 million when the Tax Cuts and Jobs Act sunsets in 2026.

» Want to reduce capital gains taxes? Consider these strategies

Thinking ahead to what size your estate might become and keeping exemption limits in mind is useful when formulating an estate plan.

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Which taxes might come into play

Estate tax planning incorporates several types of transfer taxes at the federal and state level.

Federal taxes

The federal exemption limit combines:

  • Estate tax. Upon your death, the transfer of your taxable estate — which includes assets such as cash, securities and other property — could be subject to estate tax, if the value of your taxable estate surpasses the federal exemption limit. Generally, assets inherited by your spouse, if a U.S. citizen, aren't subject to estate tax given the unlimited marital deduction.

  • Gift tax. When giving money or other assets away without the expectation of receiving anything in return, you could be subject to gift tax if your lifetime gifts, including your estate, exceed the federal exemption amount. Gifts to your spouse, if a U.S. citizen, are excluded from this tax.

However, there is an annual exclusion amount, or gift amount, that you can give before triggering gift taxes. In 2022, the annual exclusion amount is $16,000 per person, per year, or $32,000 for a married couple to any one person. There is no limit to the number of different gift recipients.

  • Generation-skipping transfer, or GST, tax. If you give money to grandchildren or relatives two or more generations younger than you, or to a non-family relation more than 37½ years your junior, GST tax may kick in. For gifts that skip a generation and are outside the annual exclusion amount, GST tax applies the highest federal estate tax rate on the asset transfer.

State taxes

States can levy their own estate and gift taxes in addition to federal taxes. Some states have an inheritance tax paid by the beneficiary who inherited assets upon someone’s death. At the federal level, an inheritance isn't considered income. But some states deem an inheritance to be taxable. In those states, inheritance tax rates can range from 1% to 18%, and in some cases are progressive, meaning that the larger the inheritance, the more you would owe.

How to minimize your estate tax burden

If you have or anticipate amassing a large estate, finding ways to shelter your assets can be prudent, given the possibility of reduced exemption limits and a potentially substantial tax hit.

Giving during your lifetime to reduce your taxable estate

With the annual exclusion limit for gifting, you can remove assets from your taxable estate each year by giving to your heirs. And you can foot the bill for medical bills or tuition without being subject to taxes so long as the payments are made directly to the medical facility or school.

While a $16,000 annual gift or tuition bill may not seem like much, consider this example:

A husband and wife have three married adult children and nine grandchildren, a total of 15 heirs (three children, three in-laws, nine grandchildren) and can give $32,000 to each heir without triggering any gift taxes. That means the husband and wife can remove $32,000 x 15 heirs = $480,000 from their estate each year.

Now, let’s assume each of the nine grandchildren is of school age and the husband and wife would like to fund each child’s $25,000 annual private school tuition by paying their schools directly. That’s $25,000 x 9 grandchildren = $225,000 that they also can remove from their estate without any tax consequences.

Combined, the annual gifts and tuition expenses allow the husband and wife to support their family while significantly shrinking their taxable estate by $705,000 every year. In this particular case, a side benefit is that the husband and wife can provide financial support when their children's families might need it most and can witness the fruits of their generosity with their own eyes, instead of waiting until after they are gone.

You can also give to charity or 501(c)3 organizations to remove even more assets from your personal taxable estate each year.

Using irrevocable trusts to remove assets from your estate

Another way to reduce your potential future tax liability and shift assets out of your taxable estate is through irrevocable trusts. There are a wide range of irrevocable trusts to explore and consider, so you can find a strategy that fits with your situation.

Many irrevocable trusts have unique features to help minimize your future estate tax burden. With grantor retained annuity trusts, or GRATs, and spousal lifetime access trusts, or SLATs, you can move highly appreciated assets out of your estate. Intentionally defective grantor trusts, or IDGTs, allow you, the grantor or owner of the trust, to pay for any income tax owed on assets housed within the trust. This means you can further reduce your taxable estate each year by covering the cost of those annual taxes. Irrevocable life insurance trusts, or ILITs, can own a life insurance policy so that your heirs can use policy proceeds to handle estate taxes, keeping all of the assets you wanted to give intact instead of being diminished by a large tax bill.

Keep in mind that irrevocable trusts are just as they’re named — irrevocable. This means that once you execute on a strategy, making changes or reversing course won’t be easy. You’ll also need to relinquish control of the assets transferred into the trust. For these reasons, being careful about what you do can help ensure you don’t remove too many assets or structure your trust in a way that you might come to regret.

Consult with advisors on your estate tax planning strategy

Estate planning decisions can involve a great deal of complex decision-making and knowledge, particularly when taxes are involved. Working with an estate planning attorney and financial advisor well-versed in advanced estate tax planning strategies can help you weigh your options and find the optimal strategy to transfer wealth while minimizing taxes.

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