Did you know you own an estate? Although it may not be a mansion on a hill, you own an estate because you own property. And whether your property is a home, car, furniture, and/or life insurance, you have an estate.
And because you’re a smart, responsible, estate owner, you need to know the value of your assets and you need to plan accordingly. Sure, you want to enjoy your life and the money you work so hard for, but you also want to reach short-term and long-term financial goals by planning ahead. You want to be ready for whatever the future holds and know your loved ones will be okay if something happens to you. Estate planning helps with that.
"Creating a comprehensive plan may be uncomfortable to think about, but ultimately will reduce your stress because you and your loved ones are protected," explains Jessie Seaman, Esq., a Managing Licensed Tax Professional at Tax Defense Network. "As you develop this plan, consider how federal estate tax may affect the assets and cash you ultimately bequeath to others."
Here are five things you need to know about estate tax:
1. It's a transfer tax, not an income tax
Essentially, if you die, estate tax is a tax on property transferred from you to your heirs.
Of course, there’s more to it than that.
According to the IRS, when you die, you have the right to transfer property. However, it may cost you. At the date of your death, everything that you own and/or have special interest in will be accounted for—everything from cash and real estate to insurance and stocks. And the total of these things — the fair market value, not what you paid for them or what you think they’re worth — is called your "Gross Estate."
And once the Gross Estate is calculated, you figure out the "Taxable Estate" by deducting things like mortgages, estate administration duties, funeral expenses, and qualified charities from the Gross Estate.
Then, the IRS says, "After the net amount is computed, the value of lifetime taxable gifts (beginning with gifts made in 1977) is added to this number and the tax is computed. The tax is then reduced by the available unified credit."
Lastly, the executor of your estate must file a federal estate tax return (Form 706) within nine months of your death.
2. It only affects the wealthiest estates
If you die in 2016, you have to pay an estate tax if the total taxable value of your estate is more than $5.45 million. But if it’s less than that, your property is exempt and you can can transfer it to your heirs without being taxed. (It was $5.43 million last year and is indexed based on inflation so it will probably continue to increase as time goes on.) Due to the tax’s high exemption amount — which has increased from $650,000 per person in 2001 to $5.45 million per person in 2016 — only two out of 1,000 estates aren’t exempt (or 0.2 percent of Americans).
3. It sneaks up on you if you don't plan accordingly
Although it only affects the wealthiest estates, if you’re a middle income taxpayer, you may not be out of the woods. In fact, Scott Goble, CPA, Financial Planner with Sound Accounting, recommends basic estate planning for all families with assets of $750,000 or more for three main reasons: value, inflation, and exemption.
Value. "Families most often underestimate the value of their estate. For example, families ignore the value of life insurance policies. However, the face value of a life insurance policy is a taxable component of an estate even though the proceeds from life insurance are generally exempt from income tax." That being said, there are ways to avoid paying estate tax on life insurance. You can transfer ownership of your life insurance policy to another person (including the beneficiary) or to an irrevocable life insurance trust. But buyer beware: some group policies—especially ones done through work—don't allow you to transfer ownership at all.
Inflation. "Estate plans are typically looking forward twenty, thirty, or more years into the future. Assets worth $750,000 today can easily grow in excess of $5.45 million in thirty years."
Exemption. "Congress can lower the exemption tomorrow if they choose so families who ignore estate taxes are setting themselves up for a potential congressional sucker punch." Because IRS tax rates can change, essentially, whenever Congress feels like changing it, it’s smart to be prepared. In fact, in 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) reduced the estate tax, eliminated it completely in 2010, and brought it back again a few years later.
With good planning, no family should pay the estate tax, explains Goble. Starting an estate plan in the last few years of life does not provide adequate time to take advantage of the many ways one can transfer their assets without paying estate or gift taxes.
4. It has loopholes
When it comes to estate taxes, there are loopholes and strategies to reduce or eliminate them.
One particularly popular loophole is when estates use grantor retained annuity trusts (GRATs) to transfer property tax free: "The estate owner puts money into a trust designed to repay the estate the initial amount plus interest at a rate set by the Treasury, typically over two years. If the investment — typically stock — rises in value any more than the Treasury rate, the gain goes to an heir tax-free. If the investment doesn’t rise in value, the full amount still goes back to the estate. Such techniques have been described as a ‘heads I win, tails we tie’ bet." And because the GRAT loophole allows wealthy estates to avoid paying estate taxes when their stock or assets rise, it’s estimated that they (cough, Wal-Mart, cough) have avoided paying $100 billion in estate taxes since 2000.
Another loophole is taking advantage of the annual exclusion, the amount of money that can be transferred—in the form of cash or other assets—from one person to another annually. With annual exclusions, no gift tax is incurred, no limit exists on how many people can receive it, and it doesn’t affect the unified credit. Goble says, "For 2016, one can gift up to $14,000 ($28,000 for couples) and in so doing permanently exclude the value of the gift from their estate." (Like setting up a 529 college savings plan for your kids or grandkids!)
There is also a marriage loophole. "It’s important to note that if you’re married, the combined total of your assets can be up to $10.9 million without being hit with the estate tax (as of 2016)," explains Seaman."As such, it is wise to consider several contingent strategies that include consideration for both you and your spouse."
5. It's been around for a century
Yes, the United States federal government has been taxing the estates of dead people for one hundred years. Why? To serve as a cap on the wealthy and make them pay for something that would normally go untaxed.
However, it has fluctuated over the years. Under President Bill Clinton’s administration, for example, there was a $1 million exemption (that was not indexed to inflation) with a 55 percent tax rate. And in 2009 there was a $3.5 million exemption (again, not indexed to inflation) with a 45 percent tax rate. When exemptions are lowered, more estates have to pay, creating unrest when it comes to taxes and who has to pay what: "If the estate tax were further weakened or repealed, other taxpayers would have to foot the bill for these programs [from healthcare to education to national defense], face cuts in the benefits and services provided, or bear the burden of a higher national debt."
Any time you are planning the details of your inheritance, it is a good idea to consult with a licensed tax professional, reminds Seaman. "There are a number of items to handle in order to ensure there your estate is divided correctly and within the letter of the law. A tax professional can help you negotiate these points and prevent any unwanted issues following your passing."
And although learning about things like estate tax and survivors’ inheritance can be sad, foreboding, and downright depressing, it is important to be knowledgeable about the subject. Planning ahead can save you money and provide a sense of comfort that your family will be safe if something happens to you.
Image: Dustin Phillips