Estate tax (sometimes called inheritance tax at the state level) is affectionately referred to as the “death tax” in political circles. The gist of it: You die and the government taxes a portion of the estate you turn over to your surviving relatives.
The good news is, unless you have a pretty substantial estate, you don’t have to worry about it. For 2011, the estate tax exemption is $5 million, although this is scheduled to decrease to $1 million in 2013, which would affect a lot more people.
Once the estate owner dies, there isn’t much beneficiaries can do to reduce estate taxes, so if you plan to leave a sizable estate behind, the time to act is now. Here are some ways to ensure the government doesn’t get its hands into your pockets postmortem:
1. Spend It
This seems like an easy solution, but unless you have a very large estate, it could leave you stranded with less money than you need to last you until your death. Not to mention the fact that it’s pretty tough to determine exactly when that will be. This also isn’t the best option for those who want to leave their wealth to family or a favorite charity.
2. Give It Away
Significant estate tax savings can be achieved through gifting. That’s because the gift tax exclusion allows you to give away up to $13,000 per person in 2011 tax-free. Gifts for tuition and medical expenses you use for someone else (such a grandchild) and gifts to political organizations are also exempt from the gift tax, while gifts to qualifying charities can be deducted from the value of the gift(s) made. (See Frequently Asked Questions About the Gift Tax on the IRS website for more details.)
3. Create an Estate Plan
There are a few estate planning techniques designed to reduce estate taxes that still allow estate holders to gain access to a steady stream of income from those assets while they’re still living. These include gifting through a family limited liability company, or setting up a charitable trust.
Estate planning is tricky, so if you have a sizable estate, it’s a good idea to find a financial advisor and a tax attorney to help make sure it’s done right.
4. Remove Life Insurance Proceeds from Your Estate
Life insurance proceeds can usually be included in the insured’s estate, significantly boosting its value. A life insurance trust can be used to ensure that this often sizable portion of a person’s estate is protected from estate tax.
There is a cost to drafting and implementing this type of trust, but in many cases, this is outweighed by the tax savings. Consult a financial planner or tax advisor to determine whether it’ll work in your case.
5. Move to a Different State
If estate tax is a concern for you, it might be worth considering when you decide where you’d like to retire. The following states collect state estate and/or inheritance tax:
- District of Columbia
- New Jersey
- New York
- North Carolina
- Rhode Island
Some states follow the same exemptions as the federal estate tax, while others operate separate from state law, which could leave some residents with state estate tax to pay, even if they’re exempt from the federal estate tax.
Moving is an extreme option, but for some people it can mean leaving thousands more to their heirs, rather than to the government. Taxation rules vary widely by state, so look into what rules exist in the state you live, and in states you hope to retire in.
Death and Taxes
As the old saying goes, there’s nothing more sure in life than death and taxes. Death taxes, on the other hand, can often be minimized or avoided with careful planning. If you think your estate will be near the cutoff, find a financial planner who can help you develop a plan to ensure that your money goes to those you love, rather than to the government.