One of the main concerns for most clients, when it comes to estate planning, is the issue of federal estate tax, commonly referred to as the “death tax”. Indeed, for most people the primary goal of estate planning is to decrease or eliminate estate taxes as much as possible. While California estate taxes are no longer imposed, the federal estate tax remains. The federal estate tax rate is currently 40%. However, there is an estate tax exemption that excludes most people from paying estate taxes.
What is the federal estate tax?
According to one financial planning article, “[w]hen property is transferred to an heir after the passing away of the original owner, federal [estate] tax is paid. [These taxes] are calculated based on the fair market value of the property transferred to the beneficiary of the estate.”
How does the federal estate tax exemption work?
The federal estate tax exemption provides that an estate with a value below the exemption amount can be passed on tax-free. As of early 2017, the exemption amount is $5.49 million. This estate tax exemption is “portable,” which means that the surviving spouse of a decedent can benefit from any unused portion of their deceased spouse’s exemption. The unused portion of the exemption is then combined with the surviving spouse’s own exemption. For example, if only $3,000,000 of the husband’s $5,490,000 exemption is used, then the surviving wife can elect to add the husband’s remaining $2,490,000 exemption to her exemption. Please note: As of May 2017, President Trump’s proposed tax law changes include a repeal of the current estate tax. However, the law has not yet even been introduced as a bill in Congress
What happens if an estate exceeds the annual exclusion?
Although most estates do not exceed the $5.49 million exclusion amount, there are certainly some estate that do. If your estate exceeds the exemption amount, an estate tax of 40 percent of the excess amount will be imposed. If you are married, though, you can take advantage of the unlimited marital deduction that is available for spouses. There are also a variety of other ways that you can avoid estate taxes through the use of estate planning tools.
Using the marital deduction to eliminate estate taxes
Married couples can give a gift of an unlimited amount to each other. The value of the property gifted to the surviving spouse is subtracted from the deceased spouse’s estate. Because all assets go to the surviving spouse, there are no estate taxes imposed. A married couple can realistically protect $10.9 million from federal estate and gift taxes. This is most commonly referred to as the lifetime credit.
Understanding the “generation skipping” tax
The “generation skipping” tax is yet another type of estate tax you should be familiar with. This is a tax assessed on any assets passed on to a generation that is two or more levels below the decedent. In other words, when you leave property to your grandchildren, as opposed to your children, the IRS will assess the generation skipping tax. This particular tax also applies to a transfer of property to someone who is unrelated to you and who is 37 ½ years or more younger than you.
Generation-skipping trusts can be very helpful
The purpose of a General Skipping Trust is to minimize or avoid estate taxes on transfers made to subsequent generations. This is accomplished by holding the assets in trust and distributing the funds in a pre-defined way, to each successive generation. In this way, the entire amount of the trust is protected from estate taxes with each passing generation. A common misconception is that Generation Skipping Trusts are only for wealthy families, but most families can benefit from this type of estate planning.
The benefit of making gifts instead of leaving inheritances
Another way to avoid California inheritance taxes is by transferring property to your grandchildren or other heirs as gifts instead of inheritances. This will reduce the size of your estate, as well as decrease the amount of taxes imposed on your estate upon your death. For example, grandparents can give their grandchildren up to $14,000 each year as of 2017 (or $28,000 if they combine their gifts) to each grandchild, without incurring a gift tax. There are several options, actually. You can make an outright gift, pay health care or education expenses, put the money in a custodial account, or transfer the money into a trust.
Download our FREE estate planning checklist! If you have questions regarding California estate taxes, or any other estate planning needs, contact the Northern California Center for Estate Planning and Elder Law for a consultation, either online or by calling us at (916) 437-3500.