Estate Tax Archives - Good Life Wealth Management

Many investors are unclear about exactly what is the estate tax in the United States. Thankfully, very few people currently have exposure to the estate tax. However, for wealthy families, the estate tax can be significant. Even if you are not currently subject to the estate tax, you might be in the future, and you need to read this article. Here’s what you need to know about the estate tax and key planning strategies to reduce a future estate tax liability.

Estate Tax in 2023

Today, for 2023, the estate tax exemption is $12,920,000 per person. This is the amount that you can pass on to other people without paying any estate tax. If your estate is above this amount, your estate pays tax on the amount above the $12,920,000 threshold. The tax begins at 18% and increases to 40% once you reach $1 million above the threshold.

Spouses have separate exemptions, so a couple can effectively have an estate of $25,840,000 before owing any estate taxes. The exemption is indexed to inflation and is increasing each year. The tax must be paid by the estate before the assets are distributed to your heirs. There is no estate tax for leaving assets to your spouse, provided that your spouse is a US citizen.

Please note that the estate tax has nothing to do with “probate”. Items which are excluded from probate, such as retirement accounts, life insurance, TOD accounts, and revocable trusts, are still included in your assets for the calculation of the estate tax.

When I became a financial advisor two decades ago, the estate tax exemption was only $1 million. A lot of people were getting hit by the tax and planners were much more focused on the estate tax. Over the past 20 years, we’ve seen the exemption expanded greatly. Today, there are relatively few families who are subject to the tax, but that is likely to change.

The Future of The Estate Tax

The estate tax exemption is set to be cut in half in 2026. The current exemption amount is scheduled for sunset as part of the Tax Cuts and Jobs Act of 2017. On January 1, 2026, the exemption will drop to around $6.5 million or so (depending on inflation over the next couple of years). And immediately, people with over $6.5 million will be subject to the estate tax.

For example, if you have $11 million as an individual, your estate tax would be $0 today. But in 2026, if the exemption is $6.5 million, your heirs would owe estate tax on $4.5 million. The tax bill would be $1,745,800.

Of course, Congress could act to extend the exemption amount or even increase it. We don’t know what will happen. Personally, I don’t think there is much appetite in Washington for continuing or expanding the estate tax limits. Given the increased perception (and reality) of wealth disparity in our country, it seems unlikely to me, especially with our growing debt and deficits. It is easier to raise taxes on the 1%. There were candidates in the previous presidential election who proposed lowering the threshold to $3.5 million and increasing the tax to 45%. So, it will definitely depend on who is in control in Washington in 2025-2026, but the writing is on the wall. I think the estate tax threshold is likely going lower, maybe a lot lower. It’s a real risk.

Wealthy Americans who have $3 million to $26 million as a couple presently don’t have to think about the estate tax. But that seems likely to change, and families in this range could have a different situation in the future. Also, make sure to consider a calculation of future growth. With a hypothetical 7% annual return, $5 million will become $20 million in 20 years. Just because you don’t have an estate tax liability today is no guarantee you will not in the future.

Thankfully, there are a number of planning opportunities to reduce your future estate tax exposure.

State Estate Taxes

Before we get to estate tax strategies, there’s more bad news. A number of US states impose their own estate tax or Inheritance tax, on top of the US estate tax. And all of these states have a MUCH lower exemption, ranging from $1 million in Massachusetts to $5.9 million in New York, meaning that even if you don’t pay a federal estate tax, you could end up owing estate tax to your home state. Residents of these states will pay both the state and the federal estate tax.

States with an estate tax include: CT, DE, DC, HI, IL, MA, MD, ME, MN, NE, NY, OR, and WA. The following states impose an inheritance tax, which is similar, but imposed on the beneficiary rather than on the Estate: IA, KY, MD, NE, NJ, and PA. State estate tax rates are up to 20%. This is in addition to the Federal estate tax, so the combined estate tax could be over 50% in certain states.

Planning for the state estate tax can be very simple. Move to another state without an estate tax or an inheritance tax.

Ways to Reduce the Estate Tax

Below are ways to reduce the estate tax and it is by no means a complete list. Each of these strategies below could be a full article. There are many planning strategies we could use, depending on your individual situation.

Charitable giving. Your gifts to charity reduce your estate and if done in advance can also provide income tax benefits. Don’t forget Qualified Charitable Distributions from your IRA if you are over age 70 1/2. Better to gift over time, rather than at death, to maximize income tax deductions, which are limited to 50% of Adjusted Gross Income annually.
Use your annual gift tax exclusion of $17,000 (2023) per person. You can also pay an unlimited amount for medical and educational expenses. Pay for your grandchildren’s college directly.
Give your heirs $12,920,000 now and use up your lifetime unified exemption today. Or establish an Irrevocable Trust with this amount. When you give away or fund the trust now, the IRS cannot later charge you gift or estate taxes if the future exemption drops. You have locked in your gift at $12,900,000. And next year, if the exemption does increase, say to $13,050,000, you could give away another $150,000. This strategy is essential to do before 2026.
Establish a family limited partnership (FLP) and gift shares to your heirs. They may receive a minority discount on the FLP shares, reducing the value of the gift. This is especially helpful if you have a closely held business which is growing in value.
Establish 529 College Savings Plans for children or grandchildren. 529s pass outside of your estate, even if you control them. You can fund five years in advance ($85,000 from a single donor or $170,000 from a married couple) per beneficiary, without touching your lifetime unified exemption.
Irrevocable Life Insurance Trust. Purchase a permanent life insurance policy through the trust and the trust owns the policy. Then there is no estate tax (or income tax!) on the death benefits paid to your heirs. (If the life insurance is owned by you directly, the death benefits will be included in your Estate.)
Roth Conversion. Pre-paying the taxes on your IRAs will reduce your Estate by the amount of taxes paid. And you will leave a tax-free account to your heirs. It’s better than your estate paying 40% and then your beneficiaries having to pay another 39.6% in income taxes on the distributions from your IRA.
Other trusts can reduce your taxable estate, including charitable trusts and intentionally defective grantor trusts.

Hopefully now you have a better idea “What is the estate tax”. Unfortunately, there is uncertainty about what the future estate tax will be. And that is a big risk for families who are thinking that they are safe because today they are below the estate tax thresholds. It’s not too early for families to start planning for 2024 and 2025 before the estate tax exclusion is cut in half in 2026. If you have concerns about how the estate tax might impact your family, contact me to discuss.

Today, we look at strategies if the step-up is basis in eliminated for estate planning. There were two new proposals in the Senate this week which will target inherited wealth. These two Acts, if passed, would completely change Estate Planning for many families. The two Acts are called the STEP Act and the 99.5% Act.

The STEP Act

The STEP Act (Sensible Taxation and Equity Promotion Act), proposed by Senators Booker, Sanders, Warren, Whitehouse, and Van Hook would eliminate the Step-Up in Cost Basis. A Step-Up in Basis means that upon Death, an asset has its cost basis reset to the date of death. This allows the heirs to immediately sell an asset and receive the funds without owing any taxes. Or, if they choose to hold on to the asset, they will only owe tax on the capital gains from the date of death forward. Otherwise, they would owe taxes based on their parent’s cost basis (or other decedent).

The STEP Act proposes to eliminate the Step Up in Basis, retroactively to January 1, 2021. In its place, the Act would allow a one-time exclusion of up to $1 million of inherited capital gains. It also allows the tax to be paid over 15 years if it is an illiquid asset like a farm or business. Many older parents have held on to assets, such as mutual funds or real estate, specifically to get a step-up in basis for their children. Allowing for the exclusion of $1 million in capital gains at death will help most families. But include real estate, and many families will have over $1 million in unrealized capital gains. And those families will now be paying a capital gains tax.

The 99.5% Act

The 99.5% Act, proposed by Senator Sanders, will increase the Estate Tax paid by many families. Currently, the Estate Tax Exemption is $11.7 million ($23.4 million for a couple), which has effectively eliminated the Estate Tax for Middle Class Families. Previously, the Estate Tax Exemption was $1 million, as recently as 2003. My clients have welcomed the increase of the Estate Tax Exclusion over the past 17 years. The 99.5% Act includes provisions to:

Reduce the Estate Exemption from $11.7 million to $3.5 million.
Reduce the Unified Gift Exemption from $11.7 million to $1 million per lifetime.
Raise the Estate Tax Rate to a range of 45-65%.
Reduce the Annual Gift Tax Exclusion from $15,000 to $10,000 per donee, AND impose an annual limit of $20,000 per donor.
Reduce certain tax benefits of Trusts, Generation Skipping Trusts, etc.

While I don’t cater to the ultra-wealthy, I do have a number of Middle Class families who this will impact. Ideas in Washington often stick around until they become reality. So, if these Acts don’t get passed now, don’t think that we will never hear them again. I don’t think there will be much empathy for families who have over $1 million in unrealized capital gains. However, in some cases, children will need to sell the houses, farms, and businesses they inherit to pay for these new taxes.

How Many Taxes?

Just to be clear, the Estate Tax is in addition to any Income Tax or Capital Gains Tax. Under the two proposals, an individual who dies with $5 million, would owe a 45% Estate tax on $1.5 million (the amount above $3.5 million). That’s a $675,000 Estate Tax Bill. Then, if their cost basis was $1 million and the unrealized capital gain was $4 million, the heirs would owe another 23.8% on $3 million of capital gains. That would be another $714,000 in taxes, for a total of $1,389,000. Presently, that tax would be zero, so we are talking about a huge increase. Let’s consider eight strategies if the step-up in basis is eliminated and other changes enacted.

Ways to Reduce Taxes under STEP and 99.5% Acts

1. If the Step-Up in Basis is eliminated, you may want to pay your capital gains gradually. Aim to keep your total unrealized gains under $1 million. For example, if you have $2 million in gains, perhaps you could harvest $100,000 of gains for the next 10 years. The goal is for you to pay the gains gradually at the 15% rate and save your heirs from being taxed at the 23.8% rate.

There is a separate proposal from Biden to increase the long-term capital gains rate for taxpayers in the highest tax bracket to 39.6%. Plus you would be subject to the 3.8% Medicare Surtax and state income taxes. And then, capital gains will be taxed at 43.4% to well over 50% in many states. The government would take more than half of your gains! If that happens, it will be vitally important to harvest gains regularly to avoid pushing your heirs into the top bracket.

Roth IRAs

2. Keep your high growth investments in a Roth IRA. Beneficiaries inherit a Roth IRA income tax-free. The Roth 401(k) looks better every year, versus a tax-deferred Traditional 401(k). If higher taxes are ahead, it may be preferable to use the Roth 401(k).

3. Gradually convert your Traditional IRAs to a Roth. By pre-paying the taxes today, you can both shrink the size of your taxable estate and reduce the Income tax burden on your heirs. The current tax rates will expire after 2025. The next five years is a good window to make Roth conversions.

Plan Your Giving

4. Give away your full Annual Gift Tax Exclusion every year. Reduce your Estate. Please note that the direct payment of someone’s medical or education bills does not count towards the annual exclusion. Do not reimburse your children for those expenses – make the payment directly to the doctor, college, etc.

5. If you make charitable donations, give away your most highly appreciated securities, rather than cash. This will reduce your taxable gains. If you do want to leave money to charity, make a charity a beneficiary of your Traditional IRA. If you are over age 70 1/2, you can make charitable donations of up to $100,000 a year from your IRA as Qualified Charitable Donations, or QCDs. QCDs can reduce your taxes so you have more budget to harvest capital gains from taxable accounts. You do not have to itemize to deduct QCDs.

Other Estate Tax Savings

6. Sell your primary residence. A couple, while alive, can exclude $500,000 in capital gains on the sale of their primary residence, as long as they lived there at least 2 of the past 5 years. ($250,000 for single filers.) Let your kids inherit the house and that capital gains exclusion may be lost. Better to sell it yourself and buy another house where you don’t have the big capital gains.

7. Maximize your contributions to 529 College Savings Plans for your children or grandchildren. These will pass outside of your taxable estate and will grow tax-free for the beneficiaries. 529 Plans will not be taxable under any of these proposals, and will become a more important estate planning tool.

8. Life Insurance proceeds are not subject to income tax to the beneficiary. Additionally, If we establish your insurance policy with an Irrevocable Life Insurance Trust (ILIT) as the owner, the life insurance will pass outside of your Estate and not be subject to the Estate Tax. This didn’t matter as much when the Estate Exemption was $11.7 million. ILITs will benefit a lot more families if the Estate Exemption is reduced to $3.5 million. Include the tax benefits, and Permanent Life Insurance looks even better as an asset.

Higher Taxes Ahead?

I am proud to be an American and pay my fair share of taxes. Still, these proposals represent a massive tax increase on a lot of families. Many professional couples have the potential to have over $3.5 million before they pass away, and easily over $1 million in capital gains, too. We will keep you posted on this legislation. It seems likely that the two Acts will be merged and some compromise reached before a final version is up for a vote.

Luckily, there is a lot we can do to offset some of these proposed taxes and reduce the burden on your Estate and Heirs. Last minute strategies won’t work here, though. Families need to be thinking about their transfer of wealth years and decades ahead of time. Have questions on strategies if the step-up in basis is eliminated? Feel free to drop me an email.

What Is The Estate Tax?