Last year’s unveiled new tax plan changed the game for 2018 and onwards, taking significant steps to diminish the power and reach of the estate tax and make changes to the gift tax. Eliminating the one and raising exemptions for the other have long been goals for the Republican party, and while the President’s campaign promises have not been realized, last year’s tax plan doubled the exemptions for the estate tax law.
At first glance, the reason this is incredibly significant is because it opens opportunities for much larger savings for families with estates in the $5-$20 million range, increasing the amount of wealth you can pass onto your children. However, sometimes it is a good idea to stare a gift horse in the mouth.
While the estate tax has been further defanged, these new changes are not permanent – and most estate plans will have to make serious adjustments to take advantage of the new changes, and plan around the eventual shift back towards the old tax plan in 2026. This increase in exemptions for the estate tax may be of temporary benefit to many families, but a closer examination can give you insight into why and how you must adjust your estate plans.
Estate and Gift Taxes
The estate tax, dubbed by critics the “death tax”, is a tax levied on any estates over a certain size at a rate of 40%. No living individuals pay this tax. Rather, it is only applied to estates. Its origins trace back to the Civil War, when the government first tackled the idea of taxing large inheritances. Since 1916, the estate tax has existed as part of our country’s tax plan in some shape or form, with few exceptions, including a single year in 2010 when it did not go into effect at all.
Since then, exemptions on the estate tax have been steadily increasing. Today, a single person can pass away with a documented fortune of up to $11.2 million before their estate must pay a single penny in taxes, while for a member of a married couple, the exemption is double that at $22.4 million if the surviving spouse makes use of estate tax portability to assume the deceased spouse’ unused exemption.
This means that, for most Americans, passing away and leaving an inheritance is tax-free. And with the new estate tax, only a few thousand individuals will possibly be eligible for paying the tax.
In California, the only estate tax that applies to individuals is the federal estate tax, as California has no state estate tax, and no state inheritance tax. However, some other states do.
The gift tax is applied to individuals who are gifting money away under certain circumstances, with exceptions specifically applying to gifting money for medical or educational reasons. For example, you can pay for your granddaughter’s tuition or your cousin’s surgery without it counting towards your gift tax exemption, if you make the payment directly to the school/doctor. Giving your spouse money does not count as a gift, provided they are a U.S. citizen. Charity (gifts made to a qualified, real charitable organization) also does not count as a gift and has different tax rules.
As of 2018, you may gift a total value of $15,000 per individual annually before reporting it as a taxable gift. That means you can give your daughter the equivalent of $15,000 in gifts over the course of the year, or all at once, and give the same amount to other relatives, friends, or benefactors, before having to file taxes for it. If you gift someone, say, $20,000, then $5,000 are taxable and you have to report the gift through Form 709.
You can, however, tap into your lifetime gift tax exemption. This is a separate exemption from the annual gift tax exemption and is mutual to your estate tax exemption. Meaning, making use of your gift tax exemption transfers over to your estate tax exemption.
The lifetime gift tax exemption in 2018 is $5.6 million. Any gifts made in your lifetime beyond that total value are taxable. Using up your lifetime exemption erodes your estate tax exemption significantly.
Estate Planning and Wealth Preservation
The reason these taxes synergize well for people with the fortunes to spare, is simply because operating intelligently around the gift tax and making the most of your annual exemption while juggling between your lifetime gift tax exemption and estate tax exemption can allow you to reduce the taxes owed by your estate when you pass away. Gifting part of your wealth to your family every year lets you reduce the size of your estate, and efficiently maximize the amount of money you can pass on before you pass away.
You could also reduce taxes paid in the family by using your lifetime gift tax exemption to transfer an income-producing asset to a younger family member, with a lower income. This would effectively reduce the amount of taxes paid on that asset due to them being in a lower tax bracket, while simultaneously removing it from your estate at the cost of cutting into your lifetime gift tax exemption.
There is much more to estate planning than creating a will or a revocable trust and avoiding probate by appointing beneficiaries. Through the eyes and hands of a capable and experienced legal representative and estate planning professional, you can massively reduce the tax burden exercised onto your wealth and maximize the value of your hard work, and the impact it can have on your family for generations to come.
Looking Ahead to 2026 Taxes
The current new tax plan is only a temporary one and is slated to be reversed after 2025. This may encourage some people to make no significant changes to their estate plans, especially if they face going through the trouble of going to court over an irrevocable trust to terminate it.
However, it is recommended to contact an estate planner and make the necessary changes despite the potential reversal of the current thresholds, if only to be prepared for an unexpected tragedy.