Money may be the last thing on your mind when your loved one passes away, but it is often at the top of the state’s concerns due to the estate and inheritance tax. When a taxpayer dies, an invisible timer kicks off before their probate process begins – usually through the petition of a loved one, to start the inheritance process.
Probate is the court-supervised process by which the government facilitates the valuation and distribution of an estate’s assets within the US, as well as the resolution of an individual’s final financial responsibilities, including debt settlement, final tax liabilities, and the eventual bequeathment of an estate’s assets to its respective beneficiaries.
But probate is not without its associated costs. In addition to probate fees and attorney costs, some states charge an estate tax on the value of an estate, and some charge an inheritance tax on assets of a particular size bequeathed to specific beneficiaries.
State-specific estate and inheritance taxes are charged not only based on where the estate’s decedent lived and died but also where their beneficiaries live and where certain estate assets – such as out-of-state properties and investment assets – are located.
In addition to these state-specific taxes, the IRS may also charge a federal estate tax, which can impose a tax rate of up to 40 percent in 2022. Here’s how you can avoid most of those tax liabilities and massively reduce what your estate owes.
Inheritance Tax vs. Estate Tax
First, take a deep breath. One thing to note about inheritance and estate taxes is that they most likely will not affect you.
Inheritance taxes and estate taxes are two distinct types of tax. Inheritance taxes are imposed on assets bequeathed to a beneficiary.
This is a tax the beneficiary must pay on the value of the property or asset they receive. It is a state-specific tax – there is no federal inheritance tax, and very few states currently charge an inheritance tax. This means it is something most Americans do not have to worry about.
But here’s a crucial detail – inheritance taxes are generally only imposed on beneficiaries who are not directly related to the decedent. If you inherit from your parent or spouse, you likely won’t have to worry about paying an inheritance tax.
Estate taxes are a different matter. These are imposed on the estate rather than the recipient of the inheritance. But again, the crucial kicker: very few states impose estate taxes, and only one imposes both a state estate tax and an inheritance tax.
Federal Estate Tax
What about the federal estate tax? Again, not something most Americans will ever worry about. The federal estate tax has historically had a high exemption limit which meant that most taxpayers would not need to pay estate taxes on their assets.
This exemption limit has skyrocketed with the Tax Cuts and Jobs Act. As of 2022, you would need to leave behind an estate of over $12 million to owe any federal estate taxes. And because the excess is taxed at a progressive rate, you would need to be quite heavy, over $12 million, to reach the top tax rate of 40 percent.
Nevertheless, there are circumstances under which even modestly wealthy individuals and couples could owe federal estate taxes – the current tax legislation is only in effect until 2026, and the exemption limit will likely be reduced in the coming years. Keeping an eye on federal estate tax changes is essential if you wish to minimize the impact taxes might have on your estate.
Which States Impose Which Tax?
As of 2022, only six states impose an inheritance tax. These are:
- New Jersey
Only 13 states impose an estate tax. These are:
- New York
- Rhode Island
- District of Columbia
- Washington State
Only Maryland imposes both an inheritance tax and an estate tax. The rules surrounding both taxes differ from state to state, which means there are different rules around how much taxes estates owe, if any.
So, let’s find out how we can minimize these taxes.
Gift Giving to Reduce Estate and Inheritance Tax
Suppose you live in a state with no estate taxes but significant inheritance taxes. The total value you leave behind is significantly less than the current federal estate tax exemption limit. In that case, consider gifting assets instead of leaving them in a will.
Many states do not impose an additional gift tax, and the federal gift tax limit of $10,000 does not immediately translate into tax liability. Instead, anything gifted over $10,000 is deducted from your lifetime gift exemption limit, which is shared with your estate tax exemption limit.
Gift-giving to reduce the tax impact on your estate is not exactly a fool-proof plan. However, there are ways that later tax law changes can make you regret the decision. Thankfully, there are other options.
Estate Taxes and Living Trusts
A will can be a helpful way to ensure that your assets are distributed to the proper beneficiaries during your probate process. But trusts are the more versatile option, allowing you to create a separate entity to hold assets for you and reduce the total value of your estate.
An irrevocable trust can be written to take ownership of certain assets away from you and place them in the trust’s ownership. This is also useful for protecting certain assets from creditors if you face litigation or need to file for bankruptcy.
Irrevocable trusts cannot be amended or dissolved, as the name implies, and need professional guidance to be set up correctly. But they can be a reliable way to limit the total value of your estate in death.
Life Insurance and the Estate and Inheritance Tax
You might not have much to fear from a federal estate tax at the moment. But that can change when factoring in future tax changes and the value of a life insurance payout.
Thankfully, you can utilize a similar irrevocable life insurance trust to ensure that the value of your life insurance does not count towards the total value of your estate.
Relocating to a Different State
One way to minimize tax costs is to consolidate your assets before death. Moving an investment property or a house to a different state can be tricky. Still, you can ensure that the rest of your assets are in place and retire in a state with specific estate planning and tax advantages, such as Arizona, California, Colorado, or Florida.