When taxes are the topic, estate taxes are almost never the focus. That’s largely because they don’t affect the vast majority of people, at least not federal estate taxes.
Part of the reason the majority of Americans aren’t concerned about estate taxes because the federal threshold for a taxable estate is $11.7 million. Since few Americans have that kind of wealth, estate taxes are ignored.
But as we’ll see, the situation is very different at state level. Several states impose estate taxes on estates valued as low as $1 million.
That takes in a lot more people! Potentially millions, in fact. There are over 8 million millionaire households in the US (with some estimates running as high as 18 million!), so the number of people who could be affected by state-level estate taxes is higher than generally assumed.
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What is an Estate for Estate Tax Purposes?
While it’s easy to think of an estate as money, it actually extends to just about anything of value. And if you begin adding up everything you own that’s worth anything, it’s likely you’ll find your estate is quite a bit larger than you might believe.
Here’s a list of the assets typically included in an estate:
- Cash on hand
- Bank accounts
- Brokerage accounts
- Retirement accounts (401(k)/403(b)/457/TSP plans, as well as traditional, Roth, SEP and SIMPLE IRAs)
- Real estate (including your primary residence, as well as second homes and investment property)
- Business interests
- Deferred compensation
- Stock options
- Loans receivable (like personal loans)
- Intellectual property
- Recreational vehicles
There are several asset categories that are also included in your estate that are not normally thought of as assets by the general public.
- Proceeds from life insurance policies
- Certain annuities, or a portion thereof
- Personal property, like household furnishings, appliances, entertainment and recreation equipment, and jewelry and other valuables
- Artwork and collectibles, including numismatic coins
In some situations, the value of any of these assets – especially life insurance proceeds – can push your estate into taxable status.
Conversely, liabilities will reduce the value of your estate. For example, the outstanding balance on mortgages, auto loans, student loans, other installment loans, credit cards, and business loans will reduce the net value of your estate.
If you’ve never calculated your net worth before here’s a quick quide.
Estate Tax vs. Inheritance Tax
While the estate tax is a tax on the value of your estate at death, an inheritance tax is imposed on the amount received by the beneficiaries of your estate.
Similar to the estate tax, money and assets inherited from a spouse are not taxable for inheritance tax purposes. In addition, descendants – like children and grandchildren – generally pay no inheritance tax (the exceptions are Nebraska and Pennsylvania).
The inheritance tax will be imposed on other beneficiaries, such as siblings, nieces, nephews, cousins, and friends.
Fortunately, among states that impose death-related taxes, only Maryland has both an inheritance tax and an estate tax. All other states have one or the other (or neither), but not both.
How Much of an Estate is Taxable?
Admittedly, most Americans won’t need to deal with estate taxes, at least not at the federal level. That’s because current estate tax law provides an exemption of $11.7 million per decedent. And since very few people are worth that kind of money, the vast majority won’t be affected.
In addition, federal estate tax law holds that estates inherited by a spouse are unlimited and have no tax consequences.
Apart from federal estate taxes, at least a dozen states also impose taxes on estates valued at well below the federal estate value threshold. That holds the possibility of owing estate taxes at the state level, even though they’re not owed at the federal level.
State estate values subject to tax for 2021 are as follows:
- Connecticut, $7.1 million
- District of Columbia, $4 million
- Hawaii, $5.49 million
- Illinois, $4 million
- Maine, $5.87 million
- Maryland, $5 million
- Massachusetts, $1 million
- Minnesota, $3 million
- New York, $5.93 million
- Oregon, $1 million
- Rhode Island, $1,595,156
- Vermont, $5 million
- Washington, $2.193 million
How Much are Estate Taxes?
Though the exemption for estate taxes at the federal level is generous, the tax rate imposed is less benign.
|$0 – $10,000||18%||up to $1,800|
|$10,000 – $20,000||20%||$1,800 + up to $2,000|
|$20,000 – $40,000||22%||$3,800 + up to $4,400|
|$40,000 – $60,000||24%||$8,200 + up to $4,800|
|$60,000 – $80,000||26%||$13,000 + up to $5,200|
|$80,000 – $100,000||28%||$18,200 + up to $5,600|
|$100,000 – $150,000||30%||$23,800 + up to $15,000|
|$150,000 – $250,000||32%||$38,800 + up to $32,000|
|$250,000 – $500,000||34%||$70,800 + up to $85,500|
|$500,000 – $750,000||37%||$155,800 + up to $92,500|
|$750,000 – $1,000,000||39%||$248,300 + up to $97,500|
The initial rate starts at 18%, but quickly rises to 40% at the $1 million mark. While no tax will be due on the first $11.7 million, the tax bite on everything above is steep. You can basically figure the value of your estate in excess of $12.7 million will take a 40% tax haircut.
State-level estate taxes add to the tax burden. Hawaii and Washington have the highest tax rates, at top rates of 20%. Eight other states and the District of Columbia have rates of 16%. Two of those states are Massachusetts and Oregon, each imposing the tax on estates of $1 million or more.
Five other states, Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania impose an inheritance tax, but not an estate tax, and the maximum tax rates in those states ranges from 15% to 16%.
Maryland is alone among the states in imposing both an estate tax and an inheritance tax. The maximum estate taxes is 16%, while the top inheritance tax is 10%.
How to Minimize Estate Taxes
This is a complicated topic, which is the precise reason why advanced planning is necessary. If, based on a careful analysis, you expect your estate to be valued at well below the $11.7 million federal estate tax threshold, or the estate tax threshold in your state, specific estate tax planning probably won’t be necessary.
But if you believe you may be close to either the federal or state threshold, or you may be pushed into it by receipt of an inheritance during your lifetime, or by the payment of your life insurance policy proceeds upon your death, planning will be necessary to minimize the tax consequences for your loved ones and beneficiaries.
There are several strategies to help you accomplish this goal.
Get Professional Help
That will include a financial planner, and estate planning attorney, a certified public accountant (CPA), or a combination of two or all three. Exactly which you’ll need will depend on both the size and complexity of your estate.
A large estate will almost certainly require the services of both an attorney and a financial planner. But if you also have business interests or multiple real estate investments, a CPA may be needed as well.
A CPA will also be a necessary partner if your estate plan requires the use of a trust. That’s because the trust will require filing certain documents with the IRS, as well as filing annual trust income tax returns.
Set Up a Trust
This is a common strategy for not only minimizing estate taxes, but also ensuring your estate is distributed in the specific manner that’s consistent with your wishes.
It’s often thought this can be accomplished with a will, and while that may be necessary in conjunction with a trust, it doesn’t provide nearly the equivalent level of legal protection.
For example, a will can be contested if it excludes a family member who might be normally thought to be included in the proceeds of your estate. This can include a child or even a former spouse whom you specifically intend to exclude or may have disinherited.
There can also be complications if there’s difficulty in valuing the estate, or if it includes complex property, like a business.
Any of these situations could put your estate in probate until the situation is resolved. That would send your estate into a complicated legal process, which can take months or even years to complete, and reduce the value of the estate for the payment of legal fees.
A trust is a distinct legal entity that avoids probate and ensures your wishes will be carried out.
Trusts come in two forms, living and testamentary. A living trust is set up and funded while you are alive. A testamentary trust will be funded upon your death, such as by the proceeds of a life insurance policy.
Revocable vs. Irrevocable Trust
If the primary purpose of setting up a trust is to minimize estate taxes, you’ll need to know the difference between revocable, and irrevocable trusts.
Revocable trusts will avoid probate and ensure your estate assets are distributed according to your instructions. But they’re not designed to avoid estate taxes.
A revocable trust is more commonly associated with living trusts. You create and fund the trust while you are alive and retain control over the trust. Not only will you have the ability to manage a revocable trust, but you can also terminate it, which is where the word revocable comes into play.
While a revocable trust does give you more control over the assets within it, it also offers less legal protection – at least while you are alive. Since you have control over the assets, they can be subject to seizure by creditors, or by litigants in a lawsuit.
An irrevocable trust not only avoids probate and ensures your distribution instructions are carried out consistent with your wishes, but also has the potential to reduce estate taxes.
An irrevocable trust is formed as a completely independent legal entity. You’ll set up the trust and fund it, after which will it be completely out of your control. A trustee will be appointed to manage the trust. This can include an attorney, a financial advisor, or even an institution, like a bank or wealth management firm.
For this reason, an irrevocable trust can minimize estate taxes. Assets transferred to the trust reduce your personal estate for tax purposes, as well as the tax liability generated by income on those assets. Instead, the income generated by the assets in the trust are taxable as income to the trust. However, if you, as the creator of the trust, receive income from the trust, that income may be taxable as personal income to you.
It also offers the best protection against creditors and lawsuits, again because you have no control over the assets in the trust.
But with either type of trust, the assets within it will be distributed to the named beneficiaries in exactly the amount, manner, and timing you specify.
With either type of trust, it’s mission-critical to include all assets possible, as well as to obtain proper valuation of each. Any assets excluded from the trust will not have the protection or the specific distribution instructions the trust will provide.
Providing for the Estate Tax with Life Insurance
Apart from setting up a trust, you can also minimize or even completely cover estate taxes by purchasing a life insurance policy to pay the liability.
You’ll need to make an accurate assessment of the value of your estate, including its future value, based on your life expectancy.
You’ll need a CPA to help you with this process, as it can be quite involved and include asset valuations you’re not entirely familiar with. A CPA will also be instrumental in determining any potential changes in future estate tax levels, either at the federal or state level.
Once your estate has been properly valued, the CPA can make a determination as to the approximate amount of the estate tax liability. An insurance policy can then be purchased in an amount sufficient to cover that liability.
For example, let’s say you live in a state with an estate tax threshold of $1 million, but you expect your estate to be worth $2 million at the time of your death. If your state has a 20% estate tax, the tax liability will be $200,000 (imposed on the second $1 million, not the first because of the exemption).
By purchasing an insurance policy with a $200,000 death benefit to cover the tax liability, you’ll ensure that all assets in the estate will be passed on to your intended heirs.
Once again, if you believe you are even close to the federal or state estate tax threshold, you should invest some time – and yes, even some money – in determining if either tax may apply to your estate. You can then take a proactive approach to minimize or eliminate that liability.
If nothing else, you’ll be removing at least one burden your heirs may need to shoulder upon your death.