Understanding Estate, Gift and Inheritance Tax Exemptions
In addition to regular income tax, the federal government and certain states also collect taxes on personal estates and gifts. The highest federal rate is currently 40%; however, the actual amount is often lower thanks to various deductions, including a unified exclusion.
Estate Taxes Explained
When a wealthy person leaves his or her assets to one or more heirs, an estate tax may be imposed on the transfer. Estate taxes are paid on assets before they are distributed to heirs.
An estate equal to or less than the unified exclusion will not owe taxes. When valued higher than the unified exclusion, taxpayer will only owe taxes on the amount above the exemption. The unified exclusion is presently over $5 million and is expected to rise each year with inflation.
Because the unified exclusion applies to each person, married couples effectively have a double exclusion. Additionally, a surviving spouse can "inherit" any unused exclusion amount from the deceased spouse.
All assets, including cash, investments, trusts, business interests, real estate and more, equal the Gross Estate. Various deductions, including charitable contributions and administration expenses, reduce this amount, leaving the Taxable Estate.
One hiccup with the unified exclusion exists in gifts, which can reduce or potentially eliminate the exemption altogether.
Gift Taxes Explained
To help prevent avoidance of inheritance taxes through gift giving during life, the federal government also applies the exclusion to gifts. One amount applies to both estates and gifts, hence the "unified" name.
Individuals can give tax-free gifts to an unlimited number of people up to an annual exclusion amount for each recipient. Presently, that amount is $14,000. If gifts to any one person total more than $14,000 in a single year -- including cash, cars, houses and other assets -- the excess amount is then deducted from the unified exclusion. Excess amounts are also cumulative.
For example, if someone gives $30,000 to a family member, $16,000 -- the amount over the annual $14,000 gift exclusion -- would count against the unified total. If the person also gives $50,000 to one individual in the following year, then $36,000 would be added to the previous year's $16,000 excess amount, reducing the available unified total by $52,000. A few exceptions apply, including gifts to spouses.
Although the gift giver won't owe gift taxes until reaching the limit of the unified exclusion, he or she must file form 709 with their annual income taxes to report the excess gift amounts. If gifts exceed the unified exclusion over a lifetime, the giver must pay gift tax of 40% on that excess amount. Additionally, the exclusion can no longer be deducted from the estate value after death because it has already been used.
Note: The gift recipient rarely owes anything except by special agreement. The giver is almost always responsible for gift taxes.
Only Connecticut has a state gift tax. The annual exclusion in Connecticut is $10,000. If residents must file a federal gift tax form, they likely will have to file a state one as well.
Living Trusts and Tax Savings
A living trust is a legal arrangement that sets forth how property will be owned, managed, and maintained. Living trusts come in two basic categories: Revocable and irrevocable. A revocable trust allows the grantor—the person creating the trust—to revoke or modify the trust at will. For this reason, people generally choose the revocable kind. An irrevocable trust cannot be revoked or changed. Upon creation, the grantor gives up all ownership and control of the property: It becomes property of the trust. The grantor names a person as trustee to manage the property according to the terms of the trust. If, for example, the grantor transfers his house to the trust, the grantor may still live in the house as a tenant, but the trustee has the right to sell the property.
A trust can be a “grantor trust” or a “non-grantor trust.” The grantor retains certain powers over the grantor trust and must continue to pay income tax on any of the trust’s assets that generate revenue. The grantor relinquishes all power to a non-grantor trust. Consequently, the trust pays taxable income on the trust level.
A revocable trust is always a grantor trust, but an irrevocable trust can be either. A grantor of a revocable trust retains considerable rights. Such a trust is always a grantor trust and taxed at the grantor level. On the other hand, an irrevocable trust can be either, depending on whether the income is credited to the grantor. If the income remains with the trust, it is a non-grantor trust. If the income flows to the grantor, it is a grantor trust.
Properly structuring a trust can yield certain tax benefits. Specifically, an irrevocable grantor trust can be an effective tool for tax savings. It can save money on income, gift, and estate taxes.
Income derived from an irrevocable grantor trust flows directly out of the trust to the grantor. It is then taxed as part of the grantor’s personal income tax returns. Generally, when you sell an asset and receive more money than what you paid for it, you are taxed on the amount over your purchase price. For example, any gains made from selling stock on the open market are taxable income. However, gains made from selling assets to your irrevocable grantor trust are not taxable. Therefore, gains from selling stock to your trust are not considered taxable income.
State Inheritance Taxes
A handful of states have either an estate tax or an inheritance tax; two have both. Inheritance taxes are charged against the amount an individual heir receives. Professional advice may be beneficial due to complex rules involving location, type of property inherited, and an heir's residence and relationship to the deceased.
The following lists the estate exclusion amount (or inheritance when marked as such) and the top tax rate after this exclusion for each state. Please note these exclusion amounts may be adjusted annually for inflation.
- Connecticut - $2,000,000 exclusion then 2% tax
- Delaware - $5,430,000 exclusion (increases with inflation) then 6% tax
- Hawaii - $5,430,000 exclusion (increases with inflation) then 6% tax
- Illinois - $4,000,000 exclusion then 6% tax
- Iowa - $25,000 (inheritance) exclusion then 5% tax
- Kentucky - Up to $1,000 (inheritance) exclusion then 6% tax
- Maine - $2,000,000 exclusion then 2% tax
- Maryland - $1,500,000 exclusion (planned to increase annually and eventually match the federal exclusion in 2019) then 6% and 10% tax respectively
- Massachusetts - $1,000,000 exclusion then 6% tax
- Minnesota - $1,400,000 exclusion to increase to $2,000,000 by 2018 then 6% tax
- Nebraska - Up to $40,000 exclusion (inheritance) then 18% tax
- New Jersey - Estate and inheritance exclusions; $675,000 and up to $25,000 respectively then 6-percent tax for each
- New York - $3,125,500 exclusion before March 31, 2016, and $4,187,500 after April 1, 2016; will increase annually and match the federal exclusion in 2019 than 6% tax
- Oregon - $1,000,000 exclusion then 6% tax
- Pennsylvania - $3,500 (Inheritance) exclusion then 5% tax
- Rhode Island - $1,500,000 exclusion (increases with inflation) then 6% tax
- Tennessee - $5,000,000 exclusion then 9.5% tax (will end entirely on January 1, 2016)
- Vermont - $2,750,000 exclusion then 6% tax
- Washington - $2,054,000 exclusion (increases with inflation) then 20% tax
- Washington, D.C. - $1,000,000 exclusion then 6% tax