Chapter 5 Minimizing Estate-Related Taxes

Figuring Out Where You Are Today

Your first step in minimizing your estate-related taxes is to conduct a snapshot analysis of your current situation. Ask yourself: “Would I have any estate-related tax liability if I died today?”

To determine your estate-related tax liability, you need to perform the following activities:

Determine your estate’s value.
Conduct an inventory of what estate-planning steps you’ve already taken.
Consult the appropriate tables and charts to understand preliminary federal and state tax liability.
Look for tax traps that may unnecessarily cost you money.

After completing the preceding list of activities (this section shows you how), you’ll have a good idea which of the following categories you fall into with regards to estate-related taxes:

Significant tax-related concerns, which means you have a lot of work to do with your estate-planning team
Modest tax-related concerns, meaning you have some exposure, but with some fairly simple tactics, you can minimize your estate-related tax liability — or perhaps make that liability disappear altogether
No tax-related concerns, meaning your estate’s value is so far below the tax radar and you live in a state without any estate or inheritance taxes that you don’t need to worry at all about estate-related taxes

Determining your estate’s value

Book 5, Chapter 2 describes how you need to have a good idea of your estate’s value and gives you the tasks and steps you need to assess that value. So if you haven’t completed this estate valuation activity, get to it! This section, purely for example, assumes that your estate right now is worth $900,000 after subtracting out liabilities, such as the remaining mortgage on your home, an automobile loan, and credit card debt.

Totaling your gifts to date

The federal estate tax and gift tax are part of a unified tax system. In that system, you have a set of magic numbers that you can use in a mix-and-match manner to transfer property from your estate to others. Beyond nontaxable gifts, such as those with amounts lower than the annual exclusion amount or that are otherwise free of gift tax, your taxable gifts reduce the amount of property that you can leave to others free of federal estate taxes after you die.

You need to compile a comprehensive list of any gift giving as well as the tax impact of those gifts. Take that amount and set it aside (you use it in the next section). Also, write down your estate’s value. You use the two figures to get an idea of estate-related tax liability if you were to die today.

For example, suppose you’re generous and have given $250,000 worth of taxable gifts through the years and haven’t paid gift taxes along the way. Instead of paying the gift taxes, you filed your gift tax returns as required and are holding off on gift taxes until those amounts are settled up against federal estate taxes after you die.

Checking the tax tables

Assume, God forbid, that you were to die today. You want to compare the exemption amount magic numbers for this year (that is, the year in which you’re doing your estate-related tax planning) with the answers to the questions you’ve asked according to the steps in the “Figuring Out Where You Are Today” section (“How much is my estate worth?” and “What have I done so far?”).

Make sure you use official tax table sources, such as those available on the Internal Revenue Service website at www.irs.gov and the tax-related pages you find on the website for your state.

The federal estate tax exemption magic number for 2018 is $5.6 million. But suppose, for the sake of simplicity, that the exemption amount magic number is a nice, round $1 million, as it was in 2003. From the previous example, if your estate is worth $900,000, then you don’t have to worry about federal estate taxes, right?

Wrong! Because (again, according to the previous example) you’ve already used up $250,000 of your exemption amount through taxable gift giving. Therefore, you have a potential federal tax liability. Specifically, you may have to pay estate taxes on $150,000, calculated as follows:

Take the $1 million exemption amount.
Subtract out the $250,000 you’ve already used up through gift giving.

You have $750,000 left.
Take the $900,000 value of your estate and subtract the $750,000, leaving approximately $150,000 of your estate that may be subject to federal estate taxes.

Why “approximately”? Well, you have several available deductions to further reduce your estate’s value when it comes to tax liability, such as probate costs, funeral expenses, and appraisal fees. So that $150,000 figure may be further reduced before applying any tax rate calculations.

Even more importantly, regardless of your estate’s value, you can make two deductions that enable you to avoid having to pay any federal estate taxes. Specifically, you can use the marital deduction and charitable deduction to transfer significant amounts of property to your spouse or your favorite charities free of taxes. So if you leave most or all of your estate to your spouse or to one or more charities, then at least from a federal estate tax perspective, you don’t have any concerns right now.

Even rather modestly valued estates that are way beneath the amounts at which federal estate taxes become applicable may face significant tax liability in certain states that have fairly high estate or inheritance tax rates. So don’t forget to check your state’s tax rates.

In some states, the estate and inheritance tax system has different rates that apply to different people to whom you leave property. Those rates vary by the relationship of those people to you: a relatively low rate for your children, for example, but a fairly high rate for someone unrelated to you. Additionally, your state may have various rates that increase the more your estate is worth (in technical terms, a graduated tax system).

Therefore, you need to take a look at the answer to yet one more question — “Who gets what?” — as you’ve specified in your will and as set up in various will substitutes (see Book 5, Chapter 3), such as joint tenancy with right of survivorship, or payable on death bank accounts. The answer to this “who-gets-what?” question, in concert with “What is my estate worth?” and “What have I done so far?” helps you obtain an accurate picture of your total estate-related tax liability if you were to die today.

Looking out for tax traps

To assess your current estate-related tax liability, look for tax traps in how your estate is structured. One of the most common tax traps that can whack even the most modest estate with unanticipated and unnecessary tax liability is your life insurance policy.

Depending on how you’ve structured your life insurance — specifically, who owns your life insurance policy — the insurance’s death benefit (that is, the amount of money that will be paid to one or more beneficiaries upon your death) may be added on top of your estate’s value for federal estate tax calculation purposes.

For example, suppose your estate is valued at $500,000 and you live in a state that has neither an estate nor inheritance tax, and you’ve never given any taxable gifts before. Most likely, you have no estate-related tax liabilities — or so you hope. But suppose the following three items occur:

You have a term life insurance policy (see Book 3, Chapters 1 and 2 for more on life insurance) with a death benefit of $2 million.
You haven’t taken steps to negate the federal estate tax bite, such as setting up a life insurance trust.
You die in a year when the federal exemption amount for estate taxes is $1 million.

Guess what. You essentially have died with $1.5 million subject to federal estate taxes (the $500,000 value of your estate plus the $2 million life insurance death benefit minus the $1 million exemption amount) — even though your estate is really only worth $500,000 until you die!

So make sure that as you inventory your estate to determine its value, you work with your estate-planning team to look for tax traps in the following areas:

Life insurance (the previous example being a painful case in point)
Pensions, particularly any guaranteed future amounts that may be considered part of your estate even if you don’t have the right to take distributions right now
Other guaranteed future payments that may be considered part of your estate, such as future payments on deferred compensation, royalties, patents, monthly payments and balloon payments on money you’ve loaned out, and so on

Fortune-Telling: Picturing the Future as Best You Can

Taking a snapshot of where you are today is fairly easy if you follow the suggestions given earlier in the chapter. But most estate planning is based on some future scene — your circumstances in 5, 10, 20, 50, or even 100 more years. Impossible, you say? Far-out tax planning is much more possible than you may imagine if you take care to do the following:

Predict (as best you can) your estate’s future value when you die.
Cross-reference your life span possibilities (that is, various scenarios on how much longer you may live) against future estate-related tax liability, paying special attention to the exclusion (or exemption) amount magic numbers.
Understand the tax impact of estate-planning strategies you already have in place.
Consider the tax impact of likely or inevitable changes to your family situation.
Make your best guess at future estate-related tax exposure.

Predicting the future

No, you didn’t suddenly wind up at the state or county fair, walking down the midway and finding yourself beckoned over to the palm-reading booth. But estate planning does involve making some educated guesses about what may happen in the future.

Specifically, you need to make a rough guess about how much your estate will be worth when you die. Of course, few people know when they’ll die, other than those who have a terminal illness and who have received a medical opinion as to how much longer they have to live.

For most other people, the best course of action is to look ahead to whatever an average life span is and how many years are left between now and then. For example, suppose you’re a 35-year-old female, in fairly good health, and with a family medical history that doesn’t have a lot of your relatives dying at relatively young ages. You may reasonably expect to live until 75, 80, or maybe even older, meaning that you can predict the future and settle on one particular target age — say 80 years old.

Hopefully, you already have a general-purpose financial plan (and if you don’t, please consult with your accountant to develop one) that takes into account factors, such as

Your property’s value
Your property’s expected future earnings, such as interest on your bank accounts and growth in your stocks, annuities, and mutual funds
Your current and anticipated future income
Anticipated significant future family expenses, such as your children’s college education or weddings for your three daughters
Additional expenses that are likely, such as caring for your own aging parents and your own anticipated medical expenses (as well as those of your spouse, if applicable)
The age at which you plan to retire
Some rough idea of ordinary living expenses during your retirement years, based on the lifestyle you anticipate and your retirement-versus-estate philosophy. (Do you specifically want to leave certain amounts of property behind for your children, grandchildren, or charities, or do you plan to spend as much of your money as possible during your retirement years?)

If you’re looking at a span of 30, 40, or more years between now and the age at which you’re trying to predict your estate’s value, your calculations may be way off. But that’s okay, because all you’re trying to do is get a rough idea of whether your future estate may be worth, say, $1 million or $10 million when it comes to estate-related tax planning.

If, however, you’re close to retirement age — or maybe already in your retirement years — and you have a fairly accurate idea of how much of your estate you already are or soon will be spending during your retirement, then you can predict whether your estate’s value will be

About the same as it currently is
More than it currently is (you’re earning more in interest and retirement-years income than you’re spending, meaning that your estate continues to grow in value)
Less than it currently is because you’re gradually drawing down your estate’s value to provide retirement-years living expenses

Regardless of your current age and your particular situation, you need to have some idea of your estate’s future value so you can perform the next step — tax liability analysis — with some degree of accuracy.

Looking at several scenarios for the federal estate tax

The 2001 tax law made tax planning the financial equivalent of skeet shooting. The exemption amount magic number changed frequently between 2002 and 2009, disappeared along with the estate tax in 2010, and then came back at a lower amount in 2011. It’s been climbing ever since. How can you possibly do any tax planning in such a volatile environment?

You should set up three different comparison numbers that feed into the steps that follow. Specifically, you want to look at

The best-case scenario
The in-between scenario
The worst-case scenario

The best-case scenario

You can hope that the federal estate tax is repealed, meaning that no matter how much your estate is worth, you won’t have any federal estate tax liability. So if that’s the case, why do any tax planning at all?

Don’t get complacent. Your state may still have estate or inheritance taxes that don’t go away, either temporarily or permanently. Or Congress may decide to keep the federal estate tax repealed but still apply the gift tax and generation skipping transfer tax (GSTT). Another concern: If you receive certain government-provided medical care, your estate may get whacked for big dollars under the Estate Recovery Act.

So in the best-case scenario, you can put a big fat zero in the column titled “federal estate tax I may owe” because you won’t have an estate tax or an exemption amount. But don’t forget to consider other estate-related taxes and any related exemption amount magic numbers and other details.

The in-between scenario

The second scenario to consider — the in-between scenario — is one in which the federal estate tax hovers right around where it is now: around five and a half million dollars. Under the in-between scenario, you may find yourself having to worry about federal estate taxes, but only if your estate is worth more than that.

Again, as with the best-case scenario that has no federal estate tax, don’t forget to check your state’s estate-related taxes.

The worst-case scenario

The last scenario to consider is that the federal estate tax exemption amount will be lowered back to $1 million, meaning that if your taxable estate’s value exceeds that amount, say hello to federal estate taxes.

You should use the worst-case scenario because many people may find themselves susceptible to federal estate taxes, simply because of the possibly low exemption amount.

Blending your present strategies into the future

So far, from the preceding steps in this chapter, you have some key pieces of information with regards to estate tax planning and your future. Those keys are

Your future estate’s likely (or at least possible) value
Some raw data with regards to three different taxation scenarios that you can cross-reference against your estate’s value to predict future tax liability

Chances are, though, that if you’re not a newcomer to estate planning, you are already using some of the strategies discussed in this book, such as

Below-the-radar tax-free gift giving
Various types of trusts
The marital deduction for property you leave behind for your spouse, if doing so makes financial and tax sense

After looking at the items just listed and noting which ones are already part of your estate-planning strategy, you can come up with a revised figure — call it an adjusted future estate value — that more accurately represents what your estate is likely to be worth in the future, regardless of what it’s worth now.

The adjusted future estate value figure you come up with is what you use as you move forward to the next few steps as you try to predict future estate-related tax liability.

Considering the impact of death, divorce, and other bum breaks

Significant changes in your life, such as divorce or your spouse’s death, can dramatically affect your estate’s value.

For example, if your spouse is terminally ill and will almost certainly die before you do, and if your spouse plans to leave his or her property to you under the marital deduction, then your estate’s value will increase, perhaps significantly, after your spouse dies.

Similarly, if you expect a significant inheritance in the near future from an elderly relative who is in poor health, factor that inheritance into your calculations.

Or if a divorce is on your horizon, your estate’s value will likely be lower if you expect that a significant portion of your estate will be lost as a result of the divorce settlement.

The important point to note is that when you try to figure out your estate’s value in the future, you need to look at more than just the regular financially oriented factors, such as income, expenses, earnings on your investments, and so on, plus estate-planning strategies you already have in place. All factors are complicated enough when you look out more than a year or two. To complicate matters, you need to look at significant life changes and try to understand as best you can how they may affect your estate’s value.

Carefully comparing then betting the house and rolling the dice

You now have all the numbers you need: your estate’s future value when you die as well as three sets of tax-related data from the best-case, in-between case, and worst-case scenarios. Now you need to compare the three.

First, look at the best-case scenario: no federal estate tax at all but possible state inheritance or estate taxes and possibly other liability, such as Estate Recovery Act considerations. Based on what you think your estate will be worth, are you still looking at significant tax liability? Moderate tax liability? No tax liability?
Now look at the in-between scenario: a federal estate tax exemption amount that stays at $5.6 million. Now do the same comparisons, looking to see whether you have significant tax liability, moderate tax liability, or no tax liability.
Finally, as shampoo labels say, “lather, rinse, repeat”: Do the same comparisons and come up with the same significant/moderate/none answer for tax liability under the worst-case scenario of the federal estate tax exemption amount being at $1 million when you die.

The three answers you get for the three possible scenarios tell you how much estate-related tax-planning work you have ahead of you. If, for example, your answer under all three scenarios is “no tax liability,” then your estate-planning job is done! (Well, for tax purposes anyway; don’t forget you still need to worry about your will, probate, insurance, and so on.)

On the flip side, if your answer under all three scenarios is “significant tax liability,” then you have lots of work ahead. You specifically need to spend time with your estate-planning team looking at different tax-saving strategies.

If your answers are somewhere in between — for example, you have significant tax liability only if the federal estate tax exemption amount is $1 million, but otherwise you have either moderate or no tax liability — then you still need to consult with your estate-planning team. More likely, the basic trade-offs discussed in the next section will be enough to reduce or eliminate estate-related taxes.

Whatever answers you come up with under the three scenarios, run your results past your estate-planning team at least once just as if you were still in grade school and asking one of your parents to double-check your homework. Certainly, do most of the planning work on your own but also get a professional opinion.

Hmmm … Deciding on Strategies and Trade-Offs

Good news: Most of the basic tax-savings strategies you can employ as part of your estate planning are very straightforward and simple and require very little effort and expense on your part.

Bad news: If you don’t plan carefully, you can really mess up your estate planning and wind up with a larger tax bill. And if you really mess up, your beneficiaries may get stuck paying more taxes.

So use the following list as a starting point of tax strategies. Realize that each point has several alternatives available to you and, depending on various circumstances, may or may not be advantageous to you. Also, you need to plan ahead beyond the most immediate tax consequences and consider down-the-road tax consequences as well. The most common estate tax-related strategies available to you include

Whether you should give property to someone as a gift or leave that property in your will
Whether you should leave all your property to your spouse
How to structure your life insurance policy or policies
Whether you should use gifts below the exclusion amount
How to use double dipping on tax savings from charitable gifts

Make sure you structure your life insurance policy or policies to avoid an unpleasant surprise from the estate tax agents.

Gifting versus leaving property as part of your estate

Suppose you and your spouse have a vacation home that you purchased 20 years ago for $50,000. It was a real fixer-upper. Over the past 20 years, you’ve put about $100,000 in renovations into the home, and — even better — property values in that area have gone way up. In fact, your vacation home is now valued at $500,000, according to the most recent appraisal.

(For the sake of this example, the home is entirely in your name rather than jointly owned with your spouse, meaning that the $500,000 value is entirely within your estate.)

You decide to give the house to your oldest daughter — a freelance writer who wants to live in a secluded location. You have two options available. You can

Give the home to your daughter as a gift (being the generous parent you are).
Leave the home to your daughter in your will as part of your estate or through a trust.

Suppose you decide to give the home as a taxable gift. The home’s value — $500,000 — becomes the starting point for figuring out any gift tax liability. Starting in 2018, you have a $15,000 annual exclusion on gifts that reduces the taxable amount to $485,000 ($500,000 minus $15,000).

If, however, you decide to hang onto the home and leave it to you daughter as part of your will, the entire $500,000 would potentially be subject to federal estate taxes.

But forget about the $15,000 difference because that’s not the point. Assume your estate isn’t subjected to any federal estate taxes at all because in the year you die, your estate’s value is far below that year’s exemption amount. In fact, the value is far enough below that even if you had given the home to your daughter as a taxable gift and therefore used up part of your combined gift-and-estate exemption amount and unified credit, you still don’t have to worry about federal estate taxes.

For purposes of your estate, either giving the home to your daughter as a gift or leaving the home to her as part of your estate has the same tax impact on your estate: zero. But from your daughter’s perspective, receiving the home as part of your estate likely will cost her much less in eventual taxes if she ever decides to sell that home than if she had received the home as a gift.

Why? The answer lies in how the tax basis of the home is calculated and how for estate purposes — but not for gifting purposes — that tax basis is “stepped up” to the current value of the home at the time it was transferred.

Don’t panic. We go through it step by step. You may recognize the first part of this puzzle — calculating the tax basis — if you’ve ever owned and sold a home. To overgeneralize a bit, the tax basis of any property (not just real property like a house but any property, even including your stocks and mutual funds) is usually calculated as the price you paid for that property, plus any improvements you’ve made. (In the case of stocks and mutual funds, those improvements include dividends and capital gains that you reinvest.) In this example, the tax basis of your vacation home is $150,000: your original $50,000 purchase price plus the $100,000 in renovations you put into the home.

As noted earlier, if you leave property to someone upon your death as part of your estate, the value of that property is stepped up to the current value. Now, your daughter inherits a home worth $500,000, and that same $500,000 figure is her tax basis in that property. Assume that she doesn’t make any further improvements, and ten years later she sells that home for $700,000; she would potentially have a taxable gain of $200,000 (the $700,000 she receives minus her $500,000 tax basis).

If, however, you give the home to your daughter as a gift, she doesn’t receive a stepped-up basis and instead receives the same tax basis in the property as you had: $150,000. So if she were to someday sell that home for $700,000, her gain is now a whopping $550,000 ($700,000 minus her $150,000 tax basis) rather than the $200,000 if she had received the property from your estate upon your death.

Depending on the tax laws governing the sale of primary residences, your daughter may never owe any capital gains tax, regardless of the home’s value or how low the tax basis is. So for a house, as in this example, the gift-versus-estate consideration may be different than for stock or anything else that doesn’t qualify for the primary residence tax break. However, this tax break, the rules for rolling over gains, and the amount of the final tax break have changed occasionally in recent years. As with pretty much everything else in tax planning, you need to look ahead, make some educated guesses, and consult with your estate-planning team.

The two key points to keep in mind are

For purposes of your estate, the federal tax impact of giving property as a gift is more or less the same as leaving that property as part of your estate.
For the person to whom you give or leave the property, the down-the-road tax impact can be very different depending on which choice you make.

Imagining the ups and downs of leaving your estate to your spouse

Many married people automatically set up their wills and their overall estate plans to leave their entire estate to their surviving spouses. But they could be walking into a trap.

Suppose you and your spouse each have estates that are slightly below the federal estate tax exemption amount. Suppose you die before your spouse does, and you leave all your property to your spouse. Now suppose that your spouse dies shortly after you do, with most of the property that was once yours still unspent and part of your spouse’s estate. Guess what? Federal estate taxes probably come into the picture because by leaving your estate to your spouse, you have created a situation where estate taxes kick in. Now your spouse’s new, larger estate is higher than the exemption amount.

When deciding whether to leave property to your spouse, you need to look ahead and understand whether you’re creating a tax liability that you can avoid. (You can leave your property to your children or someone else, or place your property into a trust for your spouse.)

Using gifts below the exclusion amount

You can give gifts to anyone up to the exclusion amount (currently $15,000, and later adjusted annually for inflation) without having any tax impact at all or even using up your unified credit against down-the-road estate taxes.

If you have cash, investments, or other property that you’re certain you’ll leave to certain people — your children, for example — and if your estate is valuable enough that federal estate taxes will apply, then why not transfer that property now as gifts in small-enough chunks to stay below the gift tax radar and therefore lower the value of your taxable estate?

Why not indeed? Go to it!

Double dipping on tax savings from charitable gifts

The charitable deduction for gifts allows you to give gifts to qualified charities without worrying about gift taxes.

But guess what? You can double dip on the tax savings front and also take an itemized deduction on your federal income taxes for those same gifts. So you’re not only skipping out on gift taxes and reducing the amount of future estate taxes, but you’re also saving more money on your federal income taxes. And, if your state allows you to itemize deductions on your state income tax and to include charitable deductions, you can save even more.

So why not get two — or even three — tax deductions out of the same charitable gift?

Putting Together a Comprehensive Estate-Related Tax Plan

What’s that? You’re still a bit uncertain about where to start? Just follow this section, and before you know it, the tax portion of your estate planning will be well within your control.

Fixing the holes

You’ve identified the problem areas in your estate plan that can possibly cause your estate to get hit with unnecessary taxes, so do something about those problems — right now. If, for example, your life insurance is poorly structured so the death benefit amount causes an otherwise nontaxable estate (for federal estate tax purposes) to be taxed, then create a life insurance trust or otherwise change your life insurance policy’s ownership.

Starting on that gift giving

Remember that one way or another, the ownership of every single piece of property in your estate is eventually transferred to someone else, in some way: through your will, through your state’s intestacy laws, through a will substitute, such as joint tenancy, through a trust, or through a gift. Because you really can’t take your property with you, and if you’ve already given serious consideration to the many beneficiary decisions when you prepare your will, why not give certain property away now or in the near future instead of waiting until after your death for that property to be transferred? You can not only smooth out the property transfers in your estate by regularly giving gifts, but you can also keep a substantial amount of the overall property transfer tax-free by keeping the gifts below the annual exclusion amounts.

You can take the complete inventory of your estate that you created (see Book 5, Chapter 2, as well as the discussion earlier in this chapter) and divide the list into three columns:

Identify the intended recipient (person, charity, foundation, and so on) for that property.
Indicate whether you want to give that property as a gift rather than wait for it to be transferred as part of your estate.
Specify the year or years in which you want to make the gift.

You can also split up certain property to keep the gift amounts below the annual exclusion amounts and further reduce any potential tax exposure. For example, if you have 1,000 shares of a stock that’s relatively stable in price, and the current price per share is $50 — meaning that you have $50,000 worth of stock — you may decide that you want your oldest daughter to receive that stock to start her own portfolio. Rather than give her the entire 1,000 shares in a single year, which means that part of the gift is taxable, you can give her just enough shares this year, next year, and also the following year (and so on) to stay beneath the annual exclusion radar of $15,000 (or whatever the figure adjusts to each year along with inflation).

Setting up trusts if necessary

Book 5, Chapter 4 discusses types of trusts, many of which you can use to reduce or eliminate tax liability on your estate. Don’t go overboard — that is, don’t set up all kinds of trusts (and pay lots of fees to your attorney or financial planner) if you don’t really need to do so. By all means, set up the trusts you need to help prevent an unnecessary tax bite.

Planning ahead for property transfers upon your death

How much should you plan ahead if you leave all your estate to your spouse? How about part of your estate? Or maybe none of your estate to your spouse? Should your spouse leave his or her estate to you?

Part of your beneficiary decisions you specify in your will or through various types of will substitutes must include estimating the tax impact. If your state has an estate or inheritance tax, pay particular attention, because chances are that even if you can sidestep the federal tax bite, your estate may get hit hard by your state. So the key, just as with every other aspect of estate planning, is to plan ahead.

Schedule a meeting with you estate-planning team to discuss what tax-planning ideas may make sense for you, the pros and cons, and potential pitfalls.