How to Minimize Estate Taxes

Reduce Estate Taxes


Common Methods


  • Choose Favorable Trust Situs
  • Charitable Giving
  • Spousal Exemption
  • Gift Assets During Lifetime
  • Irrevocable Life Insurance Trusts
  • Advanced Techniques

The amount you can transfer tax-free to your beneficiaries after you die changes every year. In 2009, $3,500,000 could be transferred without paying anything in estate tax. In 2010, you could transfer an unlimited amount of money without paying any tax. In 2018, $11,200,000 can be transferred without paying anything in estate tax. The amount is $22,400,00 for couples and is indexed to inflation through 2025. This amount will continue to fluctuate from year to year. Fortunately, regardless of the exemption amount, there are always ways for you to reduce the amount of money your estate loses to tax. More importantly, there are actions you can take now to ensure you will not be trapped in case the estate tax exemption is moved lower.

Establishing a trust is an effective way to ensure your beneficiaries receive more of the estate proceeds than the government. The below sections discuss various methodologies estate holders use to minimize their taxable estates.

Choosing A Situs


Where your trust is established, not where you live, is what determines your state estate taxes. Wyoming has no personal or corporate income tax, estate tax, gifting tax, or tangible or intangible taxes. Having your trust settled in Wyoming could save you several points on staying in state. Read about domestic asset protection trusts. Reference this map for state tax rates and private trust companies.

Spousal Exemption


The most common way to save on estate tax is to take advantage of the spousal exemption. Nothing you transfer to a spouse in your estate is taxable, meaning you could transfer any amount of wealth to your spouse tax-free. This comes with a big disadvantage, however: when your spouse passes away, she will have to pay tax on her personal assets and on the assets that came from your estate. While this strategy will avoid tax temporarily, your ultimate beneficiaries -- usually, in this case, your children -- will end up having to pay all the taxes before they may receive their inheritances. A better strategy is to maximize your exemption amount.

Asset Protection Trust


Credit shelter trusts are trusts you make to hold onto all of your assets. When you die, your estate is automatically transferred into this type of trust if you make the necessary arrangements with an attorney. Your spouse has what is called a life estate in the trust's assets, meaning she has access to the assets and may use them in any way she wishes for the rest of her life. Your children are the beneficiaries of the trust's assets, meaning that when your spouse dies, her interest in the trust ends and your children ultimately receive all of the assets. This is preferable because you get to use the full annual federal estate tax exemption amount on the assets you transfer into the trust, and then your spouse gets to use her full exemption as well. This means you can effectively double your tax-free bequests and save your beneficiaries a lot of money.

Retirement Accounts


Who you want to receive your retirement accounts in the event of your death is an important consideration in your financial planning. And how you decide to leave the accounts can have significant legal and tax effects. As explained in Elder Law Answers, a surviving spouse is normally the automatic beneficiary of a 401(k) plan, but not an IRA. This is because 401(k) plans are governed by federal law, the Employee Retirement Income Security Act (ERISA). If you are married and want to leave a 401(k) plan to a beneficiary other than your spouse, your spouse would have to give consent in writing, by signing a waiver. As pointed out by Mary Randolph, JD, in Nolo, if you leave the retirement account to your estate, the funds in the account will have to go through probate and could be subject to creditors' claims. By designating a specific beneficiary for a retirement account, the beneficiary can continue to take advantage of tax-deferred growth of earnings in the account. But there may be good reasons not to have your retirement accounts transferred directly to a beneficiary. As indicated by Brenda Watson Newmann in the 401k Help Center, if you have minor children the court may appoint a trustee or guardian to receive the money. And if your children are older, you may have concerns about how they will handle the money. In this case you may want to set up a trust as the beneficiary of your retirement accounts. Kelly Greene, in an article in The Wall Street Journal, points out conflicting court rulings as to whether inherited retirement accounts are protected from creditors the same way as they were in the hands of the original owner who contributed to the account. This could be another reason to name a trust rather than an individual as a beneficiary. Natalie Choate explains in Morningstar Advisor that IRS regulations allow a trust to be the beneficiary of a retirement account and still take advantage of income tax deferral by stretching out distributions over the individual beneficiary's life expectancy if the trust meets certain requirements. If the requirements are met, the trust is considered a "see-through trust" and the life expectancy of the oldest child is used as the applicable distribution period. If the trust is set up for the benefit of one child, this distribution period is not a problem. But if you leave your retirement accounts to a trust for more than one beneficiary, all the beneficiaries must make withdrawals based on the age of the oldest beneficiary. If there is a substantial age difference, the younger beneficiaries would lose the tax advantage of potentially several years of tax-deferred growth of earnings. When you have more than one beneficiary, you may be able to set up "conduit" trusts for each beneficiary. These trusts would be named as the beneficiaries of your retirement account. If the account is an IRA, each year the required distributions would be taken and separated based on each beneficiary's age. These amounts would go into the individual trusts and would then be paid to the beneficiary. You could set up the trust so that only the minimum amount could be taken out each year. The trusts would have to be carefully and correctly set up to meet IRS requirements and to achieve your purposes. So it is advisable to consult with an estate planning CPA or attorney.

Reductions Using Life Insurance Policies


Another method of reducing estate taxes is setting up a life insurance policy in another person's name or transferring the account within three years prior of the grantor death. So long as the policy is out of the estate holder's name, annual contributions of $11,000 are considered tax free for the premium payments. For example, Tom has set up a life insurance policy for his nephew Jack under Tom's name. This policy is worth $500,000. In addition, Tom's business partner has established another life insurance policy under Shaggy's name. This policy is valued at $1,000,000. Since the second policy is listed under another name, when Tom passes away only $500,000 is taxable to Tom's estate because he did not own the policy.

Alternatively, Tom can establish an irrevocable life insurance trust. In doing so, the trust owns the policy rather than Tom. Each year, Tom purchases up to $11,000 in life insurance premiums. Ten years later, when Tom passes away, the policy pays off $110,000. None of this money is taxable to the estate. Scrappy will then live off the income of the trust. When he passes away, his beneficiaries also take the remaining principal tax free.

Between the two options, Tom must also consider ownership issues. If the policy is transferred, the grantor's ownership is forever transferred. For example, if Tom later decides to disown his nephew, the policy is non-cancelable or recoverable from Scrappy. If Tom establishes an irrevocable trust, he cannot be a trustee. Furthermore, the trust must be established at least three years prior to Tom's passing to receive avoid the estate taxes. Learn about Irrevocable Life Insurance Trusts.

Gifting


The most effective way of reducing taxes estate taxes is to set up an irrevocable trust and give away property during one's life. This type of trust is recognized by the government as a separate taxable entity and pays on its accumulated income. Since gifts may not be changed, altered, or modified, asset placed within the trust are considered gifts to the beneficiaries. Each year, an individual can make an unlimited number of $11,000 tax-free gifts of cash or other property. Couples may apply their annual exclusions valued at $22,000. These exclusions may be gifted to another couple for an exemption of $44,000 per year. By gifting annually, the size of the estate can be greatly reduced. For example, if $10,000 is annually gifted to three of your children for ten years, the taxation on the estate is reduced by $300,000. In return, beneficiaries are less likely to see an estate tax burden beginning at least 37%.

Another option is to make gifts before you die. Every year, you are permitted to give away $14,000 in gifts of cash or property to any individual. If you are married, you and your spouse may jointly give away $28,000 to any individual. This means that if you have three children, you may effectively give away $72,000 every year tax-free. This amount does not go into your estate, which means you can bring your estate below the federal exemption threshold before you die and thus pay no taxes. For example, a couple who owns $1,200,000 in assets would ordinarily be taxed on the amount over $1,000,000 (assuming they both died in 2011). This means $200,000 will be taxed. If the couple gives away $200,000 to their children over the course of three years, the couple's assets will fall below the $1,000,000 threshold and so the couple will pay no taxes on their gifts or on their estate.

Unless the property will be given to a charity, it is not advisable to gift property that has undergone tremendous capital appreciation. If appreciated property is gifted to another person, the grantor's tax basis is carried over to the recipient. Eventually, the recipient will pay higher taxes down the line. By contrast, if the property is inherited, the property is stepped up from what the grantor originally paid and the recipient will pay less in estate taxes. For example in 1986, Bruce paid $1,000,000 for Wayne Manner. Twenty years later, the property is now worth $5,000,000. If he gifts the property to Alfred, Alfred's tax basis will be $1,000,000. Thereafter, should Alfred decide to sell the property, he will pay $4,000,000 in capital gains taxes. Alternatively, if Alfred receives the property through a devised will, the tax basis will be the market value at the time of Bruce's death. If the property is still valued at $5,000,000, Alfred will have zero taxable gain.

It is better to give away property that is likely to increase in value because the estate will be worth a lot more and estate taxes will be correspondingly higher. By gifting this property, not only does this property exclude present value, but it also eliminates future appreciation on the estate. For example, if Fred and Wilma gift stock valued at $100,000 to Pebbles and the stock doubles, $200,000 is eliminated from Fred and Wilma's estate.

Charitable Giving


Individuals with charitable motives, and either a particularly high amount of assets or no beneficiaries, will be interested in charitable remainder trusts. The grantor receives an immediate and substantial tax deduction, while receiving the benefits of the property prior to their passing.

Although the trust is irrevocable, the grantor can continue receiving benefits because a fixed dollar amount or percentage of the trust's value may be reserved. For example, the trust may be required to pay the estate $10,000 annually. Alternatively, the trust document can specify annual estate payments of 7% the trust's value.

Besides removing the estate property which is subject to taxation, the grantor also receives an immediate federal income tax deduction. Furthermore, if appreciated property is sold and donated to the charitable trust, the grantor will avoid paying taxes on capital gains.

Supposes the grantor decided to later name a beneficiary, yet receive the same charitable benefits. A charitable lead trust may be established to discount the value of the gift, but keep the property for the intended beneficiaries. will benefit from making charitable gifts. Because all gifts to nonprofit organizations may be made without any tax, you can give away a large amount of money to bring yourself below the yearly threshold. While this will reduce the amount of money your beneficiaries receive, it will also reduce the amount you pay in taxes and ensure that some of your wealth goes to support a cause you believe in.

Charitable Lead Trust: Improving Donation Levels to Charity

Educating our children in the value of investment is crucial to laying the foundation for many years positive financial decisions. When searching for a method in which to educate a child in investment strategies while also benefiting a local charity, consider investing in a Charitable Lead Trust. The following is an overview of CLT and the various advantages in donating property under a Trust program. Charitable Lead Trusts are a nice investment tool in which the donor is able to personally witness the benefit of the donation of property to a charitable organization. As the owner of an asset, such as real estate, rather than simply allowing heirs to sell the property and making a monetary contribution to a charity, consider moving the real estate, or other tangible property, into a Charitable Lead Trust. In doing so, you will avoid the capital gains tax associated with selling the property and the charitable organization, once the property is transferred to them, can turn around and sell the property without paying tax on the gains they earn, thereby enabling the charity to reinvest and benefit from your contribution.

In addition to the transfer of property prior to your death, under the Charitable Lead Trust, the donor of the asset can place the property into a trust which pays a percentage of the asset's values to a chartiable organization over a specific number of years. Following the end of the term, the value of the property, is then transferred to the heirs of the estate. While not a taxable deduction, the Charitable Lead Trust will provide your heirs will a tax free benefit applied to any value growth of the property while it was placed under Charitable Lead Trust. Should the donor outlive the terms of the Charitable Lead Trust, in addition to the avoidance of capital gains tax, the donor is also given an immediate "charitable" tax deduction based on the lifetime value of the gift.

Avoiding probate tax, and the associated sale of property by your heirs, is a crucial aspect of financial planning. As part of a financial planning portfolio, when investing in real estate, consider the use of a Charitable Lead Trust as an option to improve the tax advantages for you now, as well as for your heirs at the time of your death. In doing so, the charitable organization will benefit greatly and both you and your heirs will avoid the taxes required by the Internal Revenue Service.

AB Trusts


Setting up an AB Trust is appropriate for couples who wish to maximize property gifts to beneficiaries after both spouses pass, while ensuring the surviving spouse is financially comfortable during their lifetime. Rather than conveying the estate to the spouse, the property is owned by the trust. The surviving spouse may use the property, even though it is not directly owned. The property is therefore not subject to estate taxation when the second spouse passes because it is not legally owned.

Prior to establishing this trust, couples need to also consider its drawbacks. The trust is irrevocable and cannot be changed once one of the spouses pass. Thereafter, the surviving spouse has limited rights to use the property. Furthermore, an attorney or accountant will need to be hired to determine how to divide the couple's assets. Such consultation is needed to avoid certain tax consequences.

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