When someone dies, their assets are transferred to any heirs. In some cases, this is a taxable event. The transfer of wealth could trigger estate taxes, which are paid by the estate of the deceased person. Or it could trigger inheritance taxes, which are paid by those who inherit money.
Estate taxes could be charged on either the federal or state level, whereas inheritance taxes are charged only by a limited number of states. Fortunately, with the right tax planning and estate planning, it might be possible to avoid either type of so-called death tax.
Here's what you need to know about how to avoid inheritance tax that either you or your heirs might have to pay.
What is inheritance tax?
Estate tax and inheritance tax are both taxes that are sometimes charged when property transfers upon a death. Both the federal government and some states charge estate taxes, but there are no federal inheritance taxes and only a limited number of states impose inheritance taxes.
Estate tax rules impose taxes depending on the size of the estate. A lot of money must typically change hands in order for any estate tax to be owed. For example, according to IRS estate tax law, you can pass up to $12.6 million in assets in 2022 without owing any federal estate tax. Only assets above this level are taxable. And you do not pay estate tax if your assets transfer to a surviving spouse.
Additionally, if the first spouse who dies does not use their $12.6 million in exemptions because they leave their money to their widow, the second spouse inherits that exemption and can pass $24.12 million in property without tax.
When the transfer of wealth triggers estate tax, the tax is paid out of the estate directly. People who inherit don't pay it; the money is taken from the assets the deceased left behind. Sometimes, if there's not enough cash in the estate, this could trigger the forced sale of some property.
Inheritance taxes are not based on the value of the estate but on the relationship of the person inheriting to the person who died. Close relatives, such as spouses, may not be taxed, depending on the state's rules.
Because estate tax and inheritance tax rates and rules differ depending where you live, it's important to know your own state's laws when figuring out how to manage your money in preparation for your death or after inheriting wealth.
States with inheritance tax
The states that charge inheritance taxes include:
- New Jersey
States with estate tax
The states that charge an estate tax include:
- New York
- Rhode Island
- Washington, D.C.
- Washington State
States with both
Only Maryland has both a state estate tax and a state inheritance tax.
8 ways to avoid inheritance tax
Based on what you just learned, if you believe you or your loved ones may be subject to inheritance tax, there are things you can do now to reduce that tax liability in the future.
1. Start giving gifts now
One way to reduce or avoid estate and inheritance taxes is to give gifts during your lifetime. If you give away your money and property while you are alive, your estate will be smaller and might not rise above the threshold at which taxes would be triggered.
You are allowed to give away up to $16,000 to any number of people you want over the course of a year without it being considered a taxable gift. This is $16,000 per recipient and per gifter. So if you have a spouse, you could collectively give away up to $32,000 to any number of recipients without having to report the gift and without any gift tax consequences.
This means if you and your spouse had three children, together you could give $32,000 per year to each child for a total of $96,000 in gifts each year without any tax implications.
If you exceed these $16,000 per person per recipient gift amounts, that still doesn't necessarily trigger taxes. It just counts against your lifetime gift and estate tax exemption. This exemption is $12.6 million per person, and it applies to both gift tax and estate taxes. If you use some of this $12.6 million exemption during your lifetime because you give gifts of more than $16,000 in a year, that reduces the exemption that applies to your estate when you die.
The $12.6 million threshold is in place only until 2025, after that it reverts back to a $5.49 million exemption (adjusted for inflation) unless Congress takes action. If you think your estate will exceed this, you might want to give as much away now as you possibly can before the exemption is reduced. If you give away $12.6 million to your kids now, you'll get to claim the exemption and it won't matter if it is reduced later.
2. Write a will
If you write a will, the will needs to be probated unless you arrange for the transfer of assets using means that avoid probate. This means that unless your estate is a small one, a court process will be necessary to facilitate the transfer of wealth.
Usually, simply writing a will doesn't allow you to skip the probate process. You'd need to take other steps, such as creating a trust or titling any real estate as joint tenants with rights of survivorship in order for the property to pass outside probate.
When your estate is probated, the value of your assets is determined and the court decides who inherits based on your instructions. The value of the transferred wealth determines how much estate tax is owed, and the relationship to those who inherit determines how much inheritance tax is owed. There's not a lot of techniques you can implement simply by writing a will that reduces these taxes.
However, you can use a will to specify who inherits. And if you instruct that all your money goes to your spouse, this would allow you to avoid inheritance tax and estate tax because spouses aren't subject to either when they inherit a deceased partner's money or assets.
3. Use the alternate valuation date
The value of your estate determines how much estate tax you'll owe, but that value can change over time. Under the Tax Cuts and Jobs Act, you are allowed to use an alternate valuation date. That means you could opt to pay taxes on the value of the estate as determined six months subsequent to the date of death, rather than the value on the date of death itself.
If you want to use the alternate valuation date, you must calculate the entire value of the estate as of that date — you can't be selective and use different dates for different assets. The only exception is if assets were sold between the date of death and the alternative valuation date, in which case their value on the day of the sale applies. If assets declined simply because of the passage of time, their value also must be determined as of the date of death.
If you want to use an alternate valuation date, you must elect to do so within one year of the time the estate tax return has to be filed. Once you decide to use the alternate valuation date, you can't change your decision.
4. Put everything into a trust
If you want to avoid estate taxes, you could create an irrevocable trust and transfer the ownership of your property into the trust. You will no longer own the assets, and they won't be a part of your estate. The trust will become the owner of the assets.
When you die, the trust remains the owner of the assets. But the beneficiary, or the person whom the trust benefits, can change to your chosen heirs.
This doesn’t work with all types of trusts, only with irrevocable trusts. And you have to give up some control over the property because the trust is the official owner and you can't revoke the transfer of property to the trust. But no trust assets transfer upon death, so no estate or inheritance taxes are charged.
5. Take out a life insurance policy
You can purchase a life insurance policy and the death benefit payout is not taxable. Your beneficiaries (the people you choose to receive the death benefit) can use these proceeds to pay inheritance or estate tax. This doesn't reduce or eliminate these taxes, but it makes them easier to pay because they won't have to be paid out of your estate or out of the assets of the person who inherits.
You could also set up an irrevocable life insurance trust. In this case, you would hold the policy within the trust and the trustee would pay premiums from trust assets. Upon death, the trustee collects the life insurance proceeds and uses it to pay for funeral expenses and to distribute the money to the beneficiaries of the trust. This keeps the life insurance policy out of the estate so the value of the policy doesn't count toward determining whether the estate is taxable.
If you’re interested in using life insurance for tax purposes, then be sure to investigate the best life insurance companies before you decide on a policy.
6. Set up a family limited partnership
You can create a family limited partnership and transfer ownership of assets to that limited partnership. The family limited partnership will become a separate entity from you and your heirs. And you can give a gift of a partnership interest to your family members. The value of the gift is discounted under tax rules.
Say, for example, you create a family limited partnership and transfer $1 million of assets to it. And you give your children a 20% ownership interest. Because your children don't have control over the assets, the gift of the ownership interest isn't worth $200,000 but rather is considered to be worth much less.
7. Move to a state that doesn't have an estate or inheritance tax
Because only a minority of states impose inheritance taxes, relocating as a retiree could potentially help you save.
Just be sure you understand what state's rules will apply. When it comes to inheritance tax, the state where the deceased person lives matters — not the state where the person who inherits lives. So if you live in Pennsylvania, which charges inheritance taxes, and you leave money to your kids who live in Florida, which doesn't, your kids will still face inheritance taxes.
As for estate taxes, the location of the property determines which rules apply.
8. Donate to charity
Finally, you can donate money to charity to avoid estate taxes. There is an unlimited tax deduction for leaving money to charities, so any assets you leave to a qualifying organization won't be part of your taxable estate.
Start planning now to reduce your tax burden
Paying estate or inheritance taxes can be expensive and complicated (though the best tax software can make it easier.) If you want to spare your loved ones the loss of assets or the aggravation that results from a huge inheritance tax bill, it's best to take steps as soon as possible to reduce that burden.
This can include:
- Make estate-planning a priority. It is never too early to make a will, create an overall estate plan, or start gifting assets.
- Talk with a financial advisor or estate-planning attorney. A lawyer or financial professional can provide you with advice on how to reduce your tax bill.
- Choose your retirement location strategically. Retirement is often a good time to relocate to a state that has more favorable rules on taxation of inheritances.
By planning in advance, you can reduce or even eliminate estate or inheritance taxes. It's worth making the effort so your loved ones can inherit your hard-earned money or property without having to give a cut to the federal or state government.
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