There is a federal estate tax in the United States that that can have a serious impact on your legacy, because it carries a 40 percent maximum rate. That’s the bad news, but the good news is that most people do not have to pay the tax, because it is only applicable on very large transfers.
The estate tax credit or exclusion is the amount that can be passed along before the death levy is applied. At the time of this writing in 2020, the amount of this exclusion is $11.58 million. This figure is updated annually to account for inflation, so it will probably be slightly higher next year.
We should point out the fact that there is an unlimited marital estate tax deduction. This allows you to transfer of any amount of property to your spouse free of the death tax, with one caveat. Your spouse must be an American citizen to take advantage of this deduction.
However, there is an estate tax efficiency strategy for people that are married to non-citizens in the form of a qualified domestic trust. In a future post, we will examine the details.
Anyone that hears about the existence of the estate tax would consider lifetime gift giving as a way to transfer assets tax-free. The estate tax was originally enacted in 1916, and at that time, people did give gifts while they were living to avoid the estate tax.
This was the lay of a land for several years, but in 1924, the legislature enacted a federal gift tax to close this loophole. It was repealed in 1926, but a gift tax was reenacted in 1932, and it has been in place ever since then.
The gift tax and the estate tax are unified, so the $11.58 million exclusion is a unified exclusion. It applies to large gifts that you give while you are living along with the value of the estate that will be passed along to your heirs after you are gone. To sum it up, if you give $11.58 million in tax-free gifts while you are living, the entirety of your estate would be subject to the death tax.
Additional Gift Tax Exemptions
In spite of the fact that there is a federal gift tax that is unified with the estate tax, it is still possible to give tax-free gifts to reduce your transfer tax exposure. There is an annual gift tax exemption that sits completely apart from the unified lifetime gift and estate tax exclusion.
During the current calendar year, the amount of this annual exemption is $15,000.
This is not $15,000 in total gifts. Under the tax code, you are allowed to give as much as $15,000 to any number of gift recipients, equaling any amount of money in total, in a tax-free manner each year. If you are exposed to the federal estate tax, you can use this exclusion to transfer quite a bit of money free of taxation.
To provide a simple example, let’s say that you are married, and you and your spouse have five married children together. You would have a $15,000 exemption, and your spouse would also be able to give $15,000 to any number of people tax-free within a calendar year.
As a couple, you could give $30,000 to all of your children and their spouses every year without incurring any transfer tax liability. Since you have five married children, this would be a total of $300,000 annually. The tax-free transfers are an obvious benefit, and you would also be reducing the taxable value of your estate by $300,000 each year. If you make this a regular practice, the tax benefits would be considerable.
This strategy can be used to give direct gifts, and the annual exclusion can be used to fund certain types of trusts. It can also be utilized to facilitate tax efficient asset transfers between members of a family limited partnership.
In addition to the annual gift tax exemption, there are two other exemptions that you should be aware of if you are concerned about transfer taxes. You can pay school tuition for students tax-free, and you can also pay medical bills for others in a tax-free manner, including health care insurance premiums.
New York State Estate and Gift Taxes
New York has a state estate tax with a $5.85 million exclusion in 2020. If your estate is valued at more that 5 percent over this amount, the exclusion would not be available. All of the estate would be subject to taxation.
There is no New York gift tax per se, but there is a so-called “clawback provision.” If you give gifts within three years of your death, the value of those gifts would be added to the value of your estate for tax purposes.
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