Estate Taxes
Common Questions About Estate Taxes
1. Who has to pay estate taxes?
Depending on how much you own when you die, your estate may have
to pay estate taxes before your assets can be fully distributed.
Estate taxes are different from, and in addition to, probate expenses
(which can be avoided with a revocable living trust) and final income
taxes (on income you receive in the year you die). Some states also
have their own death/inheritance taxes.
Federal estate taxes are expensive - in 2004 they start at 45%
and quickly go up to 48%. And they must be paid in cash, usually
within nine months after you die. Since few estates have this kind
of cash, assets often have to be liquidated. But estate taxes can
be substantially reduced or even eliminated - if you plan ahead.
Your estate will have to pay estate taxes if its net value when
you die is more than the "exempt" amount set by Congress
at that time. Here is the current schedule:
Year of Death........."Exemption" Amount
2004 & 2005.............$1.5 million
2006, 2007 & 2008.....$2 million
2009.......................$3.5 million
2010........................N/A (repealed)
2011 and therafter.....$1 million
2. How is the net value of my estate determined?
To determine the current net value, add your assets, then subtract
your debts. Include your home, business interests, bank accounts,
investments, personal property, IRAs, retirement plans and death
benefits from your life insurance.
3. How can I reduce or eliminate my estate taxes?
In the simplest terms, there are three ways:
- If you are married, use both estate tax exemptions.
- Remove assets from your estate before you die.
- Buy life insurance to replace assets given to charity and/or
pay any remaining estate taxes.
4. Using Both Exemptions
If your spouse is a U.S. citizen, you can leave him or her an
unlimited amount when you die with no estate tax. But this can be
a tax trap, because it wastes an exemption.
Let's say, for example, that Bob and Sue together have a net estate
of $3 million and they both die in 2004. Bob dies first. He leaves
everything to Sue, so no estate taxes are due then. When Sue dies,
her estate of $3 million uses her $1.5 million exemption. The tax
bill on the remaining $1.5 million? $705,000!
But if, instead, Bob and Sue plan ahead, they can use both their
exemptions and pay no estate taxes. A tax-planning provision in
their living trust splits their $3 million estate into two trusts
of $1.5 million each. When Bob dies, his trust uses his $1.5 million
exemption. When Sue dies, her trust uses her $1.5 million exemption.
This reduces their taxable estate to $0, so the full $3 million
can go to their loved ones.
This planning can also be done in a will, but you would not avoid
probate or enjoy the other benefits of a living trust.
5. Removing Assets From Your Estate
A great way to reduce estate taxes is to reduce the size of your
estate before you die. So, spend some and enjoy it!
Also, you probably know whom you want to have your assets after
you die. If you can afford it, why not give them some assets now
and save estate taxes? It can be very satisfying to see the results
of your gifts--something you can't do if you keep everything until
you die. Appreciating assets are usually best to give, because the
asset and future appreciation will be out of your estate.
Assets you give away keep your cost basis (what you paid), so the
recipients may have to pay capital gains tax when they sell. But
the top capital gains rate is only 15% (assets held at least 12
months). That's a lot less than estate taxes (45-48%) if you keep
the assets until you die.
Some of the most commonly-used strategies to remove assets from
estates are explained below. Note that these are all irrevocable,
so you can't change your mind later.
6. Tax-Free Gifts
This is easy and it doesn't cost anything. Each year, you can
give up to $11,000 ($22,000 if married) to as many people as you
wish. So if you give $11,000 to each of your two children and five
grandchildren, you will reduce your estate by $77,000 (7 x $11,000)
a year - $154,000 if your spouse joins you. (This amount is now
tied to inflation and may increase every few years.)
You can give more, but it will use up some of your estate tax exemption.
That's because it's a combined gift and estate tax exemption. While
you're living, it's a gift tax exemption; after you die, it's an
estate tax exemption.
Charitable gifts are unlimited. So are gifts for tuition and medical
expenses if you give directly to the institution.
7. Irrevocable Life Insurance Trust (ILIT)
An easy way to remove life insurance from your estate is to make
an ILIT the owner of the policies. As long as you live three years
after the transfer of an existing policy, the death benefits will
not be included in your estate.
Usually the ILIT is also beneficiary of the policy, giving you
the option of keeping the proceeds in the trust for years, with
periodic distributions to your spouse, children and grandchildren.
Proceeds kept in the trust are protected from irresponsible spending
and creditors, even ex-spouses.
8. Qualified Personal Residence Trust (QPRT)
A QPRT lets you save estate taxes by removing your home (a substantial
asset) from your estate now; yet you can continue to live there.
Here's how it works.
You transfer your home to a trust for a period of time, usually
10 to 15 years. During this time, you continue to live in your home.
When the time is up, it transfers to the trust beneficiaries, usually
your children. If you wish to stay there longer, you may make arrangements
to pay rent. If you die before the trust ends, your home will be
included in your estate, just as it would without a QPRT.
There's more. A QPRT "leverages" your estate tax exemption.
Since your children will not receive the house until the trust ends,
its value as a gift is reduced. For example, if the current value
of your home is $250,000 and you put it in a QPRT for 15 years,
its value for tax purposes could be as little as $75,000. That leaves
much more of your exemption for other assets.
9. Grantor Retained Annuity Trust (GRAT) and Grantor Retained
Unitrust (GRUT)
These are much like a QPRT. The main difference is that a GRAT
or GRUT lets you transfer an income-producing asset (stock, real
estate, business) to a trust for a set number of years, removing
it from your estate, and still receive the income. (If the income
is a set amount, the trust is called a GRAT. If the income fluctuates,
it's called a GRUT.)
When the trust ends, the asset will go to the beneficiaries (usually
your children). Since they will not receive it until then, the value
of the gift is reduced. If you die before the trust ends, the asset
will be in your estate.
10. Family Limited Partnership (FLP) and Limited Liability Company
(LLC)
Both FLPs and LLCs let you reduce estate taxes by transferring
assets like a family business, farm, real estate or stocks to your
children now, yet you keep full control.
For example, you and your spouse can set up an FLP or LLC and transfer
assets to it. In exchange, you receive ownership interests. Though
you have a fiduciary obligation to other owners, you control the
FLP or LLC either through the general partner or as manager, and
you can give ownership interests to your children, which removes
value from your taxable estate.
The ownership interests cannot be sold or transferred without your
approval. And because there is no market for these interests, their
value is discounted. So you can transfer the underlying assets to
your children at a reduced value - without losing control.
11. Charitable Remainder Trust (CRT)
A CRT lets you convert a highly appreciated asset (like stocks
or investment real estate) into a lifetime income without paying
capital gains tax when the asset is sold. It also reduces your income
and estate taxes, and lets you benefit a charity that has special
meaning to you.
With a CRT, you transfer the asset to an irrevocable trust. This
removes it from your estate. You also get an immediate charitable
income tax deduction.
The trust then sells the asset at market value, paying no capital
gains tax, and reinvests in income-producing assets. For the rest
of your life, the trust pays you an income. Since the principal
has not been reduced by capital gains tax, you can receive more
income over your lifetime than if you had sold the asset yourself.
After you die, the trust assets go to the charity you have chosen.
12. Charitable Lead Trust (CLT)
A CLT is just about the opposite of a CRT. You transfer an asset
to the trust, which reduces the size of your estate and saves estate
taxes. But instead of paying the income to you, the trust pays it
to a charity for a set number of years or until you die. After your
death, the trust assets will go to your spouse, children or other
beneficiaries.
13. Buying Life Insurance
Depending on your age and health, buying life insurance can be
an inexpensive way to replace an asset given to charity and/or to
pay any remaining estate taxes. The three-year rule mentioned earlier
does not apply to new policies. But you should not be the owner
of the policy - that would increase your taxable estate and estate
taxes. To keep the death benefits out of your estate, set up an
ILIT and have the trustee purchase the policy for you.
14. How To Reduce or Eliminate Estate Taxes Summary Chart
1. If Married, Use Both Exemptions
(Living Trust with Tax Planning)
• Uses both spouses' estate tax exemptions
• Protects up to $2.6 million from estate taxes (for family
businesses that qualify)
2. Remove Assets From Estate
(Make Annual Tax-Free Gifts)
• Simple, no-cost way to save estate taxes by reducing size
of estate
• $11,000 ($22,000 if married) each year per recipient (amount
now tied to inflation)
• Unlimited gifts to charity and for medical/educational
expenses paid to provider
(Transfer Life Insurance Policies to Irrevocable Life Insurance
Trust)
• Removes death benefits of existing life insurance policies
from estate
• Included in estate if you die within 3 years of transfer
(Qualified Personal Residence Trust)
• Removes home from estate at discounted value
• You can keep living there
(Grantor Retained Annuity Trust / Grantor Retained Unitrust)
• Removes income-producing assets from estate at discounted
value
• You can continue to receive income
(Family Limited Partnership)
• Discounts value of business, farm, real estate or stock
• Lets you start transferring assets to children now to
reduce your taxable estate
• You keep full control
(Charitable Remainder Trust)
• Converts appreciated asset into lifetime income with no
capital gains tax
• Saves estate taxes (asset out of estate) and income taxes
(charitable deduction)
• Charity receives trust assets after you die
(Charitable Lead Trust)
• Removes asset from your estate, saving estate taxes
• Income goes to charity for set time period, then trust
assets go to loved ones
3. Buy Life Insurance
(Through Irrevocable Life Insurance Trust)
• Can be inexpensive way to pay estate taxes
• Death benefits not included in your estate
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