What Do I Need to Know About Estate Taxes?

Editors' Note: This article is excerpted from The Charles Schwab Guide to Finances After Fifty, available in bookstores nationwide. Read more at http://schwab.com/book.

Most of us have come to fear estate taxes. But at least for now, federal estate taxes are an issue for the very wealthy only—or for those with an estate valued at more than $11.58 million (or $23.16 million for a married couple) in 2020. But before you crack open the champagne, a couple of caveats: First, we can never say never when it comes to Congress. The current tax rates are scheduled to "sunset" at the end of 2025 where they will revert back to 2017 levels (adjusted for inflation) under the Tax Cuts and Jobs Act (TCJA). However, anything can happen in the future. Second, even though you may not have to pay federal estate taxes, you may be on the hook for state taxes.

That said, the best you can do is plan with the information you have. Below I cover basics as well as strategies for anyone whose estate may still be impacted. But you should be aware that estate taxation—or just about anything having to do with estate planning— is complex. It’s always best to work with an experienced estate planning attorney.

What's Your Estate Worth?

An estate tax calculation starts with your gross estate. The basic principle for valuing property is generally its fair market value, or "the price at which property would change hands between a willing buyer and a willing seller... both having reasonable knowledge of relevant facts." The date of valuation is either the date of death or six months later (whichever date is chosen, it applies to all property). (Note: Real estate used in a closely held business or farming operation may be valued with a “special use” method.)

Sometimes the fair market value of an asset is clear-cut, but often it is not. For example, valuing a closely held family business, an interest in a limited partnership, or even a thinly traded stock can be nuanced and may require the services of a professional appraiser.

The basic rule is that a federal estate tax return is due if the gross estate exceeds the applicable exclusion amount in the year of death ($11.58 million in 2020). Often it’s obvious that a particular estate will or won’t fall above this level, particularly with the exemption set so high. However, many other estates require close scrutiny.

To value your estate, first add up your assets and subtract your debts. Then subtract the value of any assets that will be transferred to a charity on your death. If you’re married, you can also deduct the assets that will go to your spouse, provided he or she is a U.S. citizen (and therefore avoid estate tax until he or she dies).

SMART MOVE: You can avoid estate taxation of life insurance proceeds by creating an irrevocable life insurance trust (ILIT). The irrevocable trust is the owner and beneficiary of the policy. If there are no incidents of ownership retained by you, the proceeds are kept outside the estate. However, the trust must purchase the policy or the original owner must live at least three years after transferring an existing policy into the trust.

Married Couples Get a Break

It wasn’t very long ago that married couples had to set up bypass trusts (also known as AB trusts or credit shelter trusts) to take advantage of each other’s estate tax exclusions. This has changed because of portability, a relatively new provision that allows a surviving spouse to add any unused portion of a deceased spouse’s exclusion to her or his own exclusion. In other words, in 2020 a married couple can pass on up to $23.16 million to their heirs free from federal estate tax without a trust or any extra planning. The following example illustrates how portability works.

WITHOUT PORTABILITY:

Husband and wife Braverman have two equal shares of an estate valued at $23.16 million. When Mr. Braverman dies, he leaves his entire $11.58 million to Mrs. Braverman. No estate tax is due because of the unlimited marital deduction. Mrs. Braverman’s estate is now worth $23.16 million. When she later dies, the first $11.58 million can pass to her heirs free of estate tax. However, her estate must pay tax on anything above $11.58 million, at a rate of 40 percent.

WITH PORTABILITY:

Under current law, the Bravermans can take advantage of each other’s exclusion. When Mr. Braverman dies, his executor can elect to transfer his unused $11.58 million exclusion to his wife. Like before, Mrs. Braverman’s estate is valued at $11.58 million, but she now also has a $11.58 million exclusion from taxes. She can pass on the entire estate free of tax.

With portability, the couple no longer has to use the decedent’s spouse “unused” exclusion amount. In other words, before portability it was a “use-it-or-lose-it” proposition. Portability extends the time to both spouse’s exclusion until the survivor dies.

CAUTION: Portability is not automatic. The executor must file an estate tax return even if no tax is due in order for the surviving spouse to take advantage of the deceased spouse’s exemption.

Note, though, that in our example we do not address potential appreciation. With traditional estate planning, the amount excluded from the first-to-die’s estate would be put into a bypass trust for the benefit of the surviving spouse. The assets in this trust, regardless of their value and any future appreciation, would then remain outside the surviving spouse’s estate for tax purposes. The trust could appreciate to any amount and still would be free of estate tax when the surviving spouse dies. Portability doesn’t allow for unlimited appreciation in this way. If you expect large growth and the potential to go over the exclusion, you might consider a bypass trust.

CAUTION: As great as portability is for reducing or eliminating taxes, it does nothing to control how or when your heirs will receive assets. As a result, you may still want to discuss the benefits of a particular type of trust with your attorney. For example, in a second marriage a qualified terminable interest property (QTIP) trust can provide for the surviving spouse as well as for the children from a first marriage.

Strategies to Reduce Your Taxable Estate

Even with the generous exclusion, some estates may be subject to tax. You may want to discuss the following with your estate planner:

Gifting: Lifetime gifting has many advantages, not the least of which is the pleasure you can derive by seeing your beneficiaries enjoy your gift. In 2020 you can gift up to 15,000 to an unlimited number of people in a single year ($30,000 for a married couple “splitting gifts”) without triggering any tax. Not only do you remove the value of the gift from your estate, but you also transfer future appreciation to the beneficiary. This is one of the best ways to reduce your taxable estate at the same time that you help others. 

CAUTION: The value of property gifted within the last three years of life may be included in your estate if it has “strings attached.” For example, if you gifted a second home to a relative but retained the right to use it as you please, the fair market value of the property could revert to your estate.

• Making unlimited direct payments to qualified medical and educational institutions: Any payments that you send directly to an IRS qualified physician, hospital, or school or college on behalf of someone else aren’t counted in your annual gift tax exclusion. In other words, you can pay for your grandchild’s college education plus give them a gift of up to $15,000 a year without reducing your lifetime exclusion.
• Charitable giving: Bequests to a charity are fully deductible from estate taxes. One strategy is to transfer assets from your estate to a charitable lead trust (CLT). The charitable organization will receive an annuity for a set number of years, and at the end of the term your heirs will receive the remainder. You can also do the opposite with a charitable remainder trust (CRT). In this case, the trust will pay income for a period of time to beneficiaries you name. At the end of the stated period, the remaining trust assets pass to your charitable organization(s) of choice. You get a deduction for the portion of the value of the trust that is for the charity.
• Qualified personal residence trust (QPRT): You can transfer your home into a trust, thereby removing a portion of its value from your taxable estate. You retain the right to live in the house for a certain number of years, and at the end of that term the home is transferred to your beneficiary. You can then arrange to stay in the home and pay fair market rent. The longer the term, the smaller the gift for tax purposes. Once your home is placed in a QPRT, future appreciation accrues outside your estate. But beware that a QPRT will help avoid estate taxes only if you outlive its term of years. If you do not survive the QPRT term, the value of the residence is included in your estate.

Does Your State Have an Estate or an Inheritance Tax?

Most people focus on federal estate taxes. However, depending on where you live, you may also be liable for significant state taxes, which can take the form of either an estate or an inheritance tax (or in a couple of cases, both).

If you live in a state with an estate or an inheritance tax, you’ll need to do some extra planning. In most states the exclusion is well below the federal level of $11.58 million–plus. Also note that none of the states that have an independent estate tax have made the exclusion portable between spouses—so for some families a bypass trust could make sense.

A Word on the Generation-Skipping Transfer Tax

If you’re fortunate enough to have a large estate, and your children are also well-off, you may want to consider making gifts to your grandchildren, great-grandchildren, or unrelated people who are more than 37 ½ years your junior (yes, that’s the way the rules are written). Like other gifts, these will reduce your taxable estate. However, if the gifts don’t qualify for the $15,000 annual gift limit ($30,000 for a couple splitting gifts), they will be charged against your lifetime GST exclusion ($11.58 million in 2020) in addition to your lifetime gift tax exclusion. Any amounts over that will be taxed at 40 percent.

TALK TO AN EXPERT: No matter how you look at it, planning for an estate that is larger than the estate tax exclusion—or any complex estate—takes the expertise of an estate planning attorney. Review the basics for your own knowledge, then consult with an attorney you know and trust.