The U.S. government first established a tax on estates in 1918. (The estate tax is sometimes called the “inheritance tax” and, more recently, the “death tax.”) Soon after the estate tax was established, individuals who were anticipating that their estates might be subject to the tax began to transfer assets to their children, grandchildren, and friends to reduce the taxable estate. Subsequently a tax on large gifts was introduced to reduce these end-runs around the estate tax.
In 1976 the law was changed to provide that the tax rates on gifts to individuals and on estates would be the same. Hence, assets transferred to other individuals before death and after death are taxed in a similar— but not quite identical—way.
Current Exemption Limits
The 2014 exemption limit for estate taxes is $5.34 million. So you may leave or give away up to that amount without having to worry about estate taxes. Federal estate taxes apply to the estate of any person who dies owning more than $5.34 million. Many states also have an estate tax, but there are lots of variations so you’ll need to check with an estate planning attorney in your state for the details. In many cases, any estate tax paid to a state becomes a credit against the federal estate tax, so your estate wouldn’t pay estate tax twice.
If you die first, you will be treated as owning one-half of all assets you owned jointly with your wife. But keep in mind that your estate would include not just one-half of your jointly owned assets, but also any life insurance you own, any retirement accounts you have, and any assets you own in your own name. If the total of these assets plus your one-half of the joint assets exceeds $5.34 million, your estate would be subject to estate tax. But no tax would be due if everything goes to your wife because your estate would get a deduction against estate tax. The deduction is called a “marital deduction.”
The estate tax law provides for an “unlimited marital deduction,” which means that all of the assets left by one spouse to the other are deducted from the taxable estate. The estate tax law also provides that each individual has a lifetime credit against the estate tax liability. The general idea is to calculate the amount of the estate tax as the product of the size of the taxable estate and the schedule of tax rates and then reduce the amount of the estate tax that is payable by applying the lifetime credit.
“Bypass trusts” and “generation-skipping trusts” distinguish between the transfer of the ownership of the assets and the transfer of income that these assets produce, and they make it possible to fully use the lifetime credit while “protecting” the income of the surviving spouse. The bypass trust transfers ownership of some or all of the assets in the estate of each spouse to the trust on death, and the ownership of the income on these assets is transferred to the surviving spouse.
Both husband and wife should establish a “bypass trust” to take full advantage of the lifetime credit. Both husband and wife would stipulate in their wills that on death the assets up to the value of the unified lifetime credit be transferred to the bypass trust—so that if the family’s assets are more than the credit, each should own assets equal to the amount of the credit. The trust receives these assets on
the death of the first spouse, and the income on these assets flows to the surviving spouse. On the death of the surviving spouse, the will would provide that the ownership of these assets be transferred to children or grandchildren or some other individuals, and the bypass trusts would be dissolved. The law provides that the surviving spouse can dip into the capital of the bypass trust.
A “generation-skipping trust” is, in effect, a second-generation “bypass trust.” The gift of the income attached to assets is separated from the gift of the assets themselves. Thus an individual might direct that a specified amount of assets in the estate be transferred to the grandchildren while the income on these assets goes to one or both of their parents for a specified number of years or as long as they live. On the death of their parents, the grandchildren will receive the income on these assets and have control over these assets.
There is an upper limit on the amount that can be transferred to a generation-skipping trust without triggering a tax liability.
It is true that a living trust by itself won’t save your estate from estate taxes. Because you can amend or revoke the living trust, and take back your assets whenever you want, you really still owns the assets. And because you still own the assets, even though they are in the living trust, the federal tax rules include the assets of your living trust in your estate for estate tax purposes. Under current law, if you owns $5.34 million or more at death – in a revocable trust, or in your own name to pass through your will – estate taxes will play a role. One way to reduce the estate taxes is for you to give away assets.
“Second-to-Die” Insurance Policies
The main feature of such policies is that the insurance companies pay the beneficiaries only after the death of the second spouse—which means that the premiums must be paid for a longer time and the cash values accumulate for a longer time. The proceeds from the life insurance policies can be used to pay the estate tax. The premium on the second-to-die life insurance policy is somewhat lower than on a policy sold to an individual of the same age.
The payment of the life insurance premium reduces the value of the taxable estate while the proceeds of the life insurance policy are not taxable to the beneficiary, provided the policy is owned by an irrevocable trust. So there is a form of “tax arbitrage.”
If you buy the policy and both your spouse and you die soon thereafter, then the payoff from the policy will be large relative to the total of the premiums paid; your children will be better off because you bought the policy. If instead you and your spouse have a long life, then the sum of the premium payments will be large relative to the value of the policy, and your children may conclude that they would have been better off if you hadn’t bought the policy.
Basic planning to reduce estate taxes to the minimum can be done with either a will or a revocable trust. For a single person, estate taxes would be reduced or avoided by cutting down the value of the assets he owns at the time he dies. Speak to an estate planning attorney to know how you can reduce your estate taxes.