Estate Planning Basics

Knowing your estate tax liabilities is the first step.


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About twice a week I get a phone call from someone with an estate planning question who has no clue about the basics of this subject. Here are a few of those basics:

Federal estate taxes. Knowing your potential estate tax liability is critical to estate planning. If you were to die in 2016, the first $5.45 million of your wealth would be exempt from estate taxes. Any wealth beyond that amount would be taxed at a rate of 40 percent. For a married couple the estate tax exemption is doubled to $10.9 million. Because these exemptions are indexed to inflation, the amounts are likely to increase every year.

State estate taxes. Some states impose an additional estate tax, and the state exemption amounts are not in line with the federal ones. Typically, the state exemption is much smaller than the federal, so even an estate that doesn’t owe the federal tax might owe the state. Additionally, the top state tax on non-exempt wealth is about 16 percent. This area of taxation is in a constant state of flux. To get the most up-to-date numbers for your state, check with your state’s tax authority. 

Gifts. The $5.45 million tax exclusion mentioned above is actually a combination of exemptions for estate and gift taxes called the “unified tax credit.” Gifting wealth to family members while you are still living is an easy way to remove assets and the income they produce from your estate but still keep them in the family. One potential benefit of this tax-planning strategy is that it can take advantage of the zero or lower tax brackets of one or more family members. For example, say Joe, who is the highest tax bracket, gifts the maximum amount of assets to each of his children and/or grandchildren, who are in much lower tax brackets. This removes the assets from Joe’s estate and places them and any income they might produce elsewhere in the family, where they might be taxed more lightly. 

There are also tax exemptions for such gifts. For 2016, the annual exclusion of $14,000 means you can give as much as $14,000 to as many people as you want without incurring taxes on those gifts. And you can do this every year. If you are married, that exclusion amount doubles because they are actually considered two gifts—one from you and one from your spouse. So, Joe and his wife, Mary, can each give $14,000 to each of their four children and six grandchildren for a total of $280,000 annually out of their estate, tax-free.

Suppose Joe gifts $1 million to each of his 10 heirs for a total of $10 million. Remember, gift and estate taxes share the same rate (40 percent), and the same unified credit. Computing what Joe will have to pay in gift taxes is easy. The annual exclusions for each of Joe’s 10 gifts are $14,000, so a total of $140,000 of the $10 million in gifts is tax-exempt. Joe’s unified credit of $5.45 million also escapes the gift tax. In the end, then $4.41 million of the $10 million in gifts is taxable ($10 million minus $140,000 minus $5.45 million). At a tax rate of 40 percent, Joe must pay the tax monster $1.764 million. And if Mary gifts the same amount to their heirs, that’s another $1.764 million in taxes.

Would Joe really make that $20 million gift? Maybe. He and Mary would each save 40 percent of that $1.764 million (or $705,600) in estate taxes.

Leveraged gifts. Really want to win the estate tax game? Think gifts. Leveraged gifts.
Joe and Mary would like to enrich their grandchildren, so they each make a gift of $12,709 annually to each of their six grandchildren via an irrevocable life insurance trust. The trust pays annual premiums for six separate $1 million second-to-die life insurance policies for 15 years (then the policies will self-carry). As a result, $76,254 ($12,709 multiplied by six) is removed from their combined estate each year. After Joe and Mary are gone, the grandchildren will have $6 million tax-free at a maximum cost of $1,143,810 ($76,254 times 15).

How much do you think Joe must earn to otherwise leave his grandchildren $6 million? Would you believe about $16.66 million? Here’s the math: If Joe earns $16.66 million, he will pay the IRS 40 percent ($6.66 million) in income taxes, leaving $10 million; when he dies the IRS will get another 40 percent, leaving $6 million in his estate.

So an investment of $1,143,810 in insurance premiums will produce the same result as earning $16.66 million. Shhh. Don’t tell the IRS.