Estate Taxes: A Beginner's Guide to Minimizing Tax Burden

If you think taxes are bad while you’re alive, just wait until you die – your greedy cousin-in-law twice-removed isn’t the only one who will claw for a share.  Uncle Sam expects to be well paid when you die, and he will be, unless you actively plan your estate so that your loved ones are taken care of instead.

1. Estate Taxes vs. Probate Expenses vs. Final Income Taxes

When you die, typically you owe several sets of taxes.  The first is simple enough: you (or rather your estate) must pay normal income taxes on the money you earned the year you died.  This is unavoidable, so don’t sweat it, and the news gets better from here.

Probate expenses are only due if your estate goes into probate.  And as we learned in What’s the Difference Between a Will and a Living Trust?, if you use a living trust and pourover will (instead of a normal last will), your children can avoid (or minimize) probate obligations.  Not only will this spare them the hassle of probate court, it will also spare them probate costs – two for the price of one!

Estate taxes (also known as death taxes) are only applied to estates larger than $5.43 million (in 2015), which may sound like a lot, but that includes every scrap that you own: real estate, stocks, bonds, cash, vehicles, boats, baseball cards and the stamp collection in your attic.  Your net worth is the size of your estate. 

The federal estate tax is high, too: up to 40%, and states often impose their own estate taxes to pile on and squeeze your children for more money.  So even if your estate is worth less than $5 million, you may still owe hefty state death taxes.

2. Reducing Estate Taxes – Overview

There are generally three ways of reducing your estate tax liability:

  • If married, use each spouse’s exemption properly
  • Spend or strategically give assets before you die
  • Use life insurance to strategically replace charity gifts or pay estate taxes

These require some minor planning, but nothing extreme.  Below are expanded details on each of the above methods of slimming your estate tax liability.

3. Married Couples Making the Most of Their Exemptions

There are several ways married couples can maximize their exemption.  For the sake of simplicity, we’ll round to $5 million apiece as the exemption amount: imagine Tom and Angela are married and are worth $10 million.  When Tom dies, he can leave everything to Angela tax-free, and his unused exemption will pass to Angela, so she could use $10 million in exemption when she dies.  Simple and effective, but it comes with drawbacks: Tom gets no say over who gets his assets, and maybe he wants to pass on his first edition Lou Gehrig baseball card to his grandson?  Also, maybe Angela lives another 25 years, and remarries – she would lose Tom’s $5 million exemption.

Another way of handling their respective exemptions is for each spouse to have their own living trust, which distributes assets according to their wishes upon their deaths.  Each spouse gets to distribute their full $5 million in tax-free gifts, and the surviving spouse can still use any assets left undistributed in the trust.

How to Minimize Estate Taxes4. Removing Assets from Your Estate

You can make tax-free gifts every year, up to a certain amount per recipient (in 2015 the limit is $14,000 per recipient).  So, if you have three children and five grandchildren, you can give $14,000 to each of them in 2015, tax-free.  Further, your spouse can also give to the same recipient separately, to raise your combined tax-free gift to each person to $28,000.  The next year, you can give to them again, up to the IRS annual limit. 

Beyond these tax-free gifts, you can also give appreciating assets (e.g. real estate or stocks), and they will retain your cost basis (what you paid).  So if the asset is owned for more than a year, the only tax the recipient will owe is capital gains tax, and at 15% (for most filers) capital gains tax is far cheaper than the IRS’s 40% estate tax.

And hey, no one says you have to scrimp and save just to pass your hard-earned wealth on to that spoiled nephew of yours, why not spend some of it yourself and enjoy it?

There are plenty of other, more complex ways to remove assets from your estate while making sure they end up belonging to your children or other beneficiaries.  For example, you can set up a Qualified Personal Residence Trust, which puts your home in a trust for a number of years and then passes to your children, outside of your estate.  But these more complex methods are outside the scope of this introductory article.

5. Life Insurance Strategies

These quickly grow complex, but you should be aware that these options exist.  You can place your life insurance policy in an Irrevocable Life Insurance Trust (ILIT), and as long as you live for at least three years after setting it up, the trust is outside of your estate.  The benefits pay out when you die, and can cover your estate taxes or replace gifts you made to charity.

No one likes the idea of their hard-earned wealth going to Uncle Sam after they die, and we all want to make sure our loved ones are provided for and secure.  If your estate is worth more than $5 million, talk to your accountant about options for reducing the estate taxes that your spouse or children will have to pay upon your death.  You may not be around to hear it, but they will be thanking you later when they can avoid probate court, fees and steep estate taxes.

Related Reading:

Taxes vs. Retirement: Extend Your Nest Egg by Escaping High Taxes

Why Americans Need More Retirement Savings than They Think