A Guide To Federal Estate Taxes
The IRS makes it clear from the start that navigating federal estate tax liability is no easy task. On its website, the agency tells you, "The laws on Estate and Gift Taxes are considered to be some of the most complicated in the Internal Revenue Code."
If it's that complicated, what can the average taxpayer do to understand what he or she is worth and minimize how much of the estate being left to family, friends and organizations will be reduced by taxes?
The place to begin is the magic number of $5 million.
The federal tax code for 2011 allows individuals to directly pass on an estate worth $5 million or less without incurring federal estate taxes. The IRS says that means only the wealthiest 2 percent of Americans will be affected by this tax. But what is considered to be part of the estate and who places a value on it to arrive at one side or the other of the $5 million mark?
What You're Worth
Just about everything you leave behind, from homes to stocks to bank account balances to ownership in business ventures is included in what the IRS calls your "gross estate." Your assets are calculated at fair market value, meaning what they'd be worth right now if they were sold on the open market. It doesn't matter how much or how little you paid for your house. The IRS will calculate its value to your estate based on what it could be sold for today.
The next step is to subtract from your "gross estate" things like mortgage balances, debts you left behind, funeral expenses and donations you'd like to make to charitable organizations. If you are married at the time of your death and the surviving spouse is a U.S. citizen, you can take advantage of the unlimited marital deduction and subtract as much as you want out of your estate to go to that person tax-free.
What's left behind after those things are subtracted is called your "taxable estate."
The IRS will then take a look back at gifts you've been making since 1977. The IRS allows you to give up to $13,000 a year to an individual, or $26,000 if the gift is from a married couple, without incurring gift taxes. You can give away $1 million in your lifetime without paying any estate tax. Over that threshold, the IRS will do the math and compute a gift tax on your gifts back to 1977.
In the end, the estate will be taxed 35 percent of the amount that is over $5 million.
Keeping Up With The Code
The tax code isn't set in stone. The exemption amounts that will apply to estates in 2011 are different from those that will apply in 2012, when the $5 million gets a little boost for inflation. But in 2013, the $5 million exemption is scheduled to drop back to $1 million and the rate of taxation on estates will increase to 55 percent. If you're dealing with an estate that was initiated in 2010, the U.S. Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act eliminated the estate tax all together. The bottom line is that the rules continue to change.
Avoiding Estate Taxes
Spend It: The simplest way to avoid paying estate taxes is to spend the majority of the estate while you're still alive. That can be risky since you don't know how long you will live and how much money you'll need to live on.
Give It: You can gift your estate while you're still alive. Make sure to follow the IRS gift limits to reduce your total estate value. You can also leave everything to your surviving spouse, if the spouse if a U.S. citizen, without tax penalty. But that could inflate your spouse's estate.
Will It: You can leave specific instructions in your will for your executor to donate part of your estate to charitable organizations to bring it under the threshold of the estate tax. This gives you the opportunity to designate where your money would go, instead of paying it to the government.
Trust It: There are advanced estate planning techniques involving trusts that can be put in place while you are alive or after your death. Income on trusts is reported and is taxed. Setting up a trust is something that requires professional help.
The State Of Your Affairs
In addition to federal estate taxes, your estate may also be subjected to state taxes. The rules on this vary widely from state-to-state. Consult an estate planning professional for information about your individual state.
Your first step in preparing your estate should be getting educated on the tax code. Read up on the tax law and consult a professional to advise you on structuring your assets for the best tax outcome for you and your heirs.