Strategies To Reduce Or Eliminate Your Estate Taxes
1. Who has to pay estate taxes?
Depending on how much you own when you die, your estate may have to pay estate taxes before your assets can be fully distributed. Estate taxes are different from, and in addition to, probate expenses (which can be avoided with a revocable living trust) and final income taxes (on income you receive in the year you die). Some states also have their own death/inheritance tax; you could be exempt from the federal tax and still have to pay state tax.
Federal estate taxes are expensive -- the rate is 45% in 2007 and 2008 -- and they must be paid in cash, usually within nine months after you die. Since few estates have this kind of cash, assets often have to be liquidated. But estate taxes can be substantially reduced or even eliminated -- if you plan ahead.
Your estate will have to pay federal estate taxes if its net value when you die is more than the "exempt" amount set by Congress at that time. Here is the current schedule:
Year of Death........."Exemption" Amount
1. If you are married, use both estate tax exemptions.
Let's say, for example, that Bob and Sue together have a net estate of $4 million and they both die in 2007. Bob dies first. He leaves everything to Sue, so no estate taxes are due then. When Sue dies, her estate of $4 million uses her $2 million exemption. The tax bill on the remaining $2 million is $900,000!
But if, instead, Bob and Sue plan ahead, they can use both their exemptions and pay no estate taxes. A tax-planning provision in their living trust splits their $4 million estate into two trusts of $2 million each. When Bob dies, his trust uses his $2 million exemption. When Sue dies, her trust uses her $2 million exemption. This reduces their taxable estate to $0, so the full $4 million can go to their loved ones.
This planning can also be done in a will, but you would not avoid probate or enjoy the other benefits of a living trust.
Also, you probably know whom you want to have your assets after you die. If you can afford it, why not give them some assets now and save estate taxes? It can be very satisfying to see the results of your gifts--something you can't do if you keep everything until you die. Appreciating assets are usually best to give, because the asset and future appreciation will be out of your estate.
Assets you give away keep your cost basis (what you paid), so the recipients may have to pay capital gains tax when they sell. But the top capital gains rate is only 15% (assets held at least 12 months). That's a lot less than estate taxes (45%) if you keep the assets until you die.
Some of the most commonly-used strategies to remove assets from estates are explained below. Note that these are all irrevocable, so you can't change your mind later.
If you give more than this, the excess will be considered a taxable gift and will be applied to your $1 million gift tax exemption.
Charitable gifts are unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.
Usually the ILIT is also beneficiary of the policy, giving you the option of keeping the proceeds in the trust for years, with periodic distributions to your spouse, children and grandchildren. Proceeds kept in the trust are protected from irresponsible spending and creditors, even ex-spouses.
You transfer your home to a trust for a period of time, usually 10 to 15 years. During this time, you continue to live in your home. When the time is up, it transfers to the trust beneficiaries, usually your children. If you wish to stay there longer, you may make arrangements to pay rent. If you die before the trust ends, your home will be included in your estate, just as it would without a QPRT.
There's more. A QPRT "leverages" your estate tax exemption. Since your children will not receive the house until the trust ends, its value as a gift is reduced. For example, if the current value of your home is $250,000 and you put it in a QPRT for 15 years, its value for tax purposes could be as little as $75,000. That leaves much more of your exemption for other assets.
When the trust ends, the asset will go to the beneficiaries (usually your children). Since they will not receive it until then, the value of the gift is reduced. If you die before the trust ends, the asset will be in your estate.
Here's how it works. You and your spouse can set up an FLP or LLC and transfer assets to it. In exchange, you receive ownership interests. Though you have a fiduciary obligation to other owners, you control the FLP (as the general partner) or LLC (as manager). You can give ownership interests to your children, which removes value from your taxable estate. These interests cannot be sold or transferred without your approval, and because there is no market for these interests, their value is often discounted. This lets you transfer the underlying assets to your children at a reduced value, without losing control.
With a CRT, you transfer the asset to an irrevocable trust. This removes it from your estate. You also get an immediate charitable income tax deduction.
The trust then sells the asset at market value, paying no capital gains tax, and reinvests in income-producing assets. For the rest of your life, the trust pays you an income. Since the principal has not been reduced by capital gains tax, you can receive more income over your lifetime than if you had sold the asset yourself. After you die, the trust assets go to the charity you have chosen.
2. Remove Assets From Estate
(Transfer Life Insurance Policies to Irrevocable Life Insurance Trust)
(Qualified Personal Residence Trust)
(Grantor Retained Annuity Trust / Grantor Retained Unitrust)
(Family Limited Partnership / Limited Liability Company)
(Charitable Remainder Trust)
(Charitable Lead Trust)
3. Buy Life Insurance
" FAQ on Living Trusts
" FAQ on Funding Your Living Trust
" FAQ on Understanding Life Insurance Trusts
" FAQ on Understanding Estate Taxes
" FAQ on Charitable Remainder Trusts
" FAQ on Duties and Responsibilities of Successor Trustees