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.
