Four Ways To Reduce and Avoid Estate Tax
Understanding methods to shield your estate from state or federal taxesBy Canaan Suitt, J.D. | Last updated on February 9, 2023
Use these links to jump to different sections:
- What Is Estate Tax?
- Top Ways to Avoid Estate Taxes
- 1. Transfers and Gifts
- 2. Trusts
- 3. Family Limited Partnership
- 4. Real Estate Valuation
- Getting an Estate Planning Attorney
Everyone who owns property has an estate, but not everyone is subject to estate taxes. Estate taxes only apply to wealthy individuals with very large estates.
If your estate is large enough to be taxed under federal or state law, there are strategies to reduce or avoid your estate tax liability.
“There are [ways to avoid estate taxes], although currently, some states do not have estate taxes,” says Ohio estate planning and probate attorney Jay E. Michael.
The key to reducing your estate tax burden is effective estate planning. This article will cover some of the main strategies for avoiding estate taxes.
Large estates are complicated. Once you understand the available options, it’s best to speak with an experienced estate planning lawyer.
What Is Estate Tax?
A person’s estate consists of all their assets. It includes everything from real estate and cars to stocks and retirement accounts.
There is an estate tax at the federal level and in several states, including New York, Minnesota, and Washington.
Estate taxes are taken from an individual’s estate when they die and before the estate is distributed to beneficiaries.
According to the Internal Revenue Service (IRS), the estate tax is “a tax on the right to transfer property at death.” Because of this, the estate tax is sometimes called a “death tax.”
Estate taxes are distinct from inheritance taxes. There are a couple of key differences between them:
- When they’re collected. Estate taxes come out of the estate before it’s distributed to beneficiaries. Inheritance taxes come out of what a beneficiary receives after the estate has been distributed.
- Federal and state law. At the federal level, there is only an estate tax. Inheritance taxes are only found at the state level in a few states, including Maryland, Iowa, and Pennsylvania.
The current federal estate tax exemption is $12.06 million. This means if the total value of your estate (calculated using fair market value) is under this amount, your estate is not subject to the federal estate tax.
The federal estate tax rate ranges from 18 to 40 percent, depending on how much your estate exceeds the exemption amount.
For states with the estate tax, tax laws vary in terms of the estate tax exemption amount and the tax rate.
Top Ways to Avoid Estate Taxes
There are several strategies for reducing or avoiding your estate tax liability.
In developing an estate plan, it’s essential to speak with a qualified attorney about your options and strategies.
Let’s look at some of the main options.
1. Transfers and Gifts
One way to shelter your assets from estate taxes is simply to take the assets out of your estate by transferring them to someone else.
There are a few ways to do this:
- Marital transfers. Marital transfers are a way to avoid estate taxes when one spouse dies. If your spouse is a U.S. citizen, you can give them a tax-free lifetime gift of any amount. If your spouse is not a U.S. citizen, a gift tax kicks in for marital gifts totaling more than $164,000 (as of 2022). However, this tax exemption only has limited usefulness. When the surviving spouse dies, estate taxes must be paid on the entire taxable estate, including the assets that were earlier gifted to the surviving spouse. In other words, marital transfers are useful but ultimately a delay tactic in paying the estate tax bill.
- Gifts to family members. Every year, married couples can give away a certain amount in tax-free gifts to other people, including family members. The annual gift tax limit is currently $16,000 per person. So, a husband and wife could each give away $16,000 every year for a combined $32,000 in annual tax-free gifts. Through annual gifts, married couples can reduce the value of their taxable estate while benefiting their intended beneficiaries.
- Gifts to minors. Under a couple of federal laws, individuals can give tax-free gifts to minors (individuals under 18) up to the annual gift limit ($16,000/person in 2022).
- The Uniform Gifts to Minors Act (UGMA) allows financial assets such as cash and securities to be gifted to beneficiaries who are minors without a formal trust or guardianship.
- The Uniform Transfers to Minors Act (UTMA) expands on UGMA to allow gifts of real property in addition to financial assets. Real property includes everything from real estate to intellectual property and art.
- Charitable donations. Charitable donations to organizations with 501(c)(3) tax status are tax deductible and excluded from your taxable estate. Eligible organizations include nonprofit educational institutions, religious organizations, public recreation facilities and parks, and nonprofit organizations such as the Red Cross.
Gifts are not only a way of benefitting individuals or organizations you want to help. What you gift is not counted as part of your estate for estate tax purposes.
Gifts help ensure more of your assets go to loved ones and causes you support rather than estate taxes.
Another general method to avoid estate taxes is by setting up a trust.
Generally, a trust is an estate planning document that distributes an individual’s assets to beneficiaries by first transferring those assets to a trustee.
When the individual dies, the appointed trustee distributes the trust assets according to the trust agreement. Unlike a will, trusts bypass the probate court process.
There are a few popular types of trusts, each with unique tax benefits:
There are two types of marital trusts:
- A-B trust. This type of trust is really a joint trust. The “A-B” refers to the two trusts that make it up. Part A is the marital trust established for the surviving spouse’s benefit. The trust agreement specifies the rights of the surviving spouse to the assets. For example, the surviving spouse can draw income from the trust, live in the house, etc. There is no estate tax on the assets put into this trust. Part B is a separate trust that comes into play when the surviving spouse dies and the trust assets are finally distributed to the original spouse’s intended beneficiaries.
- QTIP trust. This is similar to an A-B trust, except the surviving spouse is not given the same level of access to or control of the marital trust assets.
Irrevocable Life Insurance Trust
Irrevocable life insurance trusts are trusts designed to hold life insurance policies.
This type of trust is helpful if you are near your state or federal estate tax exemption, and your life insurance proceeds would put you over the limit.
You can put the policy in a life insurance trust to prevent life insurance proceeds from placing your estate over the exemption amount.
Putting the policy in a trust takes it out of your estate while holding it for your beneficiaries. The trust will specify when and how to pay out the life insurance proceeds after your death.
The trust is “irrevocable” since it cannot be changed once it is created.
Qualified Personal Residence Trust
This type of trust lets a married couple put their house in a trust for their beneficiaries while continuing to live in the house for a period as specified in the trust.
At the end of the trust period, the trust passes to the beneficiaries.
The potential downside to this type of trust is if the homeowner dies before the trust period is over, there is no estate tax benefit for the beneficiaries.
A charitable trust names a charitable organization as the beneficiary of the trust assets.
Assets in the charitable trust can include cash, stocks, real estate, and other property.
There are two kinds of charitable trust:
- Charitable Lead Trusts (CLT) set up a trust for a certain period of time (often the lifetime of the donor), during which a charitable organization receives financial support from the trust. The donor receives tax deductions when they set up the trust, and the charity gets financial help immediately. When the donor dies, or the trust term ends, the trust is paid out to named non-charity beneficiaries.
- Charitable Remainder Trusts (CRT) is essentially the opposite of CLTs. Instead of paying a charitable organization out of the trust and later passing the trust to a non-charity beneficiary, this type of charitable trust makes the charitable organization the trustee. As trustee, the organization makes payments to the donor or another named beneficiary during the donor’s life. When the donor dies, the trust passes to the charitable organization.
3. Family Limited Partnership
A family limited partnership (FLP) is a partnership among family members with business interests. The business interest involved could be more traditional, like a store or chain, or it could consist in things like investments and real estate.
For estate tax purposes, an FLP is beneficial because it allows family members to pool their assets and then shift them to other members in the family.
This transfer maneuver can reduce the estate size of some members while benefiting others in the family. The assets you put into an FLP and transfer to others are taken out of your estate. This can result in significant estate tax savings.
4. Real Estate Valuation
Real estate is typically valued at its highest and best use value. Generally, this measure of value benefits homeowners who get the highest value out of their real estate.
However, if the goal is to reduce the value of your estate for estate tax purposes, you can get your real estate valued for its “actual use” rather than its highest and best use.
Getting your real estate valued for actual use can result in significant savings for estate taxes.
Getting an Estate Planning Attorney
When it comes to larger estates and the type of estate tax avoidance strategies discussed in this article, it’s essential to speak with an experienced estate planning lawyer and financial planner.
A lawyer will be able to analyze your estate and formulate the best strategies to avoid estate taxes and fulfill your wishes.
Many lawyers provide free consultations for potential clients. These meetings let you get legal advice and decide if the attorney or law firm meets your needs.
To get the most out of a consultation, ask informed questions such as:
- What are your attorney’s fees and billing options?
- What is my estate value under the exemption amount?
- What will be my estate tax rate?
- What happens if I don’t pay my estate tax?
- What are the best methods to reduce my estate tax burden?
- Can I avoid capital gains taxes?
Once you have met with a lawyer and gotten your questions answered, you can begin an attorney-client relationship.
Look for an estate planning attorney in the Super Lawyers directory for legal help.
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