Best Ways to Protect Your Estate and Inheritances From Taxes

Protect your estate so it goes to your family...not the government

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The term "death taxes" covers two interrelated taxes that are similar but different. Estate taxes are imposed on the overall value of an estate—everything a decedent owns at the time of their death. Inheritance taxes are levied against each individual bequest made from an estate to a beneficiary. The estate pays the estate tax and the beneficiary pays the inheritance tax, although an estate can be set up to pay that cost, too, on behalf of the beneficiary.

Estate assets can therefore be taxed twice, although not at the federal level. The Internal Revenue Service doesn’t impose an inheritance tax, nor does it tax inheritances as income. A few states do tax inheritances, however, and Maryland taxes both estates and inheritances, so you’ll want to both minimize the tax burden on your estate and protect your beneficiaries against any income tax implications or state inheritance tax liability. 

Do Living Trusts Dodge Estate Taxes?  

Trusts are legal entities that hold property that's eventually transferred to living beneficiaries at the time of the trustmaker’s death. They dodge the probate process, but not necessarily estate taxes.

An estate’s value must exceed $11.58 million as of 2020 before the balance is subject to estate taxes at the federal level, so most estates don't have to pay this tax. This exemption could possibly plummet back to the $5 million range in 2026, however, when the Tax Cuts and Jobs Act (TCJA) expires.

A revocable trust—the most common kind—won’t avoid the estate tax. The term “revocable” is key here. The trustmaker acts as trustee and can undo the trust at any time. They can dissolve it, take property back out of its ownership, or change its beneficiaries. Any income generated by a revocable trust is reported and taxed on their personal return. They still legally own the assets funded into the trust, so the IRS says it still contributes to the estate for estate tax purposes.

This isn’t the case with irrevocable trusts. The trustmaker must step aside after they create this type of trust. They can’t act as trustee and maintain control over the assets. They must appoint a third party to act as trustee. They give up ownership of the property and assets funded into it, so they aren't included in the estate for estate tax purposes when the trustmaker dies.

Irrevocable trusts file their own tax returns and they’re not subject to estate taxes because even when the trustmaker dies, the trust itself is designed to live on.

An irrevocable trust can be a handy way to avoid estate taxes if your estate is large enough to be potentially liable for them. 

Some Gifts Are Estate Tax-Free

Tax breaks abound for gift givers, but with a few catches. In most cases, you must give to a qualified charity if you're going to get any sort of tax break. The IRS offers a list of acceptable, qualified charities on its website. You can check it to make sure that the charity you’re considering is covered.

Your estate can claim a deduction for anything you give to the charity. Your gift won’t count toward the value of your estate for estate tax purposes, and you can claim a tax deduction on your personal return as well when you give during your lifetime.

The Effect of Lifetime Giving on Taxes

You'll want to keep an eye on federal gift tax rules if you’re giving to a friend or relative while you're still alive. Gifts you make during your lifetime are taxable to you, not to your beneficiaries, but you can give away up to $15,000 per person per year without incurring the tax as of 2020. This limit is indexed for inflation but it can only increase in $1,000 increments so it's only rarely adjusted every year. It's been set at $15,000 since 2018.

You can transfer a fair bit of money to your beneficiaries without incurring a gift tax if you do this each year for an extended period of years, and you'll simultaneously reduce the value of your estate. Your beneficiaries won’t have to pay an inheritance tax on the gifts if you live in a state that imposes one because you’re still living.

You can subtract the excess of any gifts over the $15,000 per person per year annual exclusion from your $11.58 million estate tax exemption, but this will leave less of the exemption to cover your estate when you die. 

Capital Gains Taxes

Although gifts to beneficiaries aren't usually taxable to them as income, this doesn’t necessarily mean that the IRS won’t have its hand out for other type of taxes, such as capital gains.

Consider this scenario: You leave the family home to your adult child. You paid $80,000 for it many decades ago. It’s worth $400,000 at the time of your death. Depending on where your home is located, your state might want a percentage of that $400,000 as an inheritance tax at the state level, but direct descendants are typically afforded the kindest rates.

Your child has a home of their own, however, and they don't want to sell it and move back into your home. Nor do they want to rent it out and deal with being a landlord. They decide to sell it.

Capital gains tax is normally payable on the difference between an asset’s basis—what it cost to acquire it—and the ultimate sales price. If you give your daughter your $400,000 home as a gift during your lifetime, not only will $385,000 of its value count against your $11.58 million estate tax exemption in the year you make the gift, but she’ll receive your cost basis in the property as well. She’ll have a $320,000 capital gain if she sells the property for $400,000.

She might not realize a dime of gain, however, if you pass the home to her as part of your estate plan after your death because the basis is “stepped up” to date-of-death value for inheritances. She hasn't realized a gain if the property was worth $400,000 on the date of your death and she sells it for that amount. She would have a just a $25,000 gain if she hangs on to the property for a year or two and ultimately sells it for $425,000. 

The basis remains at your purchase price—$80,000 in this example—if you move the property into a living trust rather than give it directly to your beneficiary.

Alternate Valuation Dates

The executor of your estate can elect an alternate valuation date for purposes of calculating any estate taxes that might be due. This date is six months after your date of death. This value would become the stepped-up basis of your assets. It would favor your beneficiary if the property increases slightly in value during this time. The cost basis remains the value at the date of your death, however, even if your estate doesn’t owe an estate tax.

Inheriting a Retirement Account 

Retirement accounts can be tricky inheritances for your beneficiaries. Distributions from these accounts are generally taxable, and tax law is pretty strict about when distributions must be taken if you leave your accounts to anyone other than your spouse. Your 30-year-old son won’t be able to sit on the account for 35 years until his retirement, letting it grow and grow undisturbed. 

In most cases, he must begin taking distributions in the year after your death, and these distributions are taxable as income to him. Exactly how much he must take depends on the method of calculation he uses. Distributions can be spread out more—which would result in less taxable income to him per year—if he uses the “single life” method. This is based on his own age and life expectancy, not yours. 

If you leave your retirement account to your spouse, however, they can simply take it over. They wouldn’t have to begin taking required minimum distributions and paying taxes on those distributions until they reach age 70½, just as if they had personally owned the account all along. 

The Unlimited Marital Deduction

All these rules presume that you're not giving assets to your spouse, either during your lifetime as gifts or via your estate when you die. Spouses are protected by an unlimited marital deduction. You can give everything you own to your partner, or leave everything to them in your estate plan, and no tax will come due—with one exception.

Gifts to spouses who aren't U.S. citizens are limited to $157,000 a year as of 2020. This limit is also indexed for inflation so it can increase periodically.

Don’t Forget State Taxes 

All these rules apply at the federal level, and state level taxes can vary considerably—not only from federal rules but from state to state as well. 

Six states impose inheritance taxes as of 2019: Maryland, New Jersey, Pennsylvania, Kentucky, Iowa, and Nebraska. Indiana used to have an inheritance tax but it was repealed in 2013.

Unless you live in one of the six states with an inheritance tax or your bequeathed property is located here, your beneficiaries won't have to worry about an inheritance tax. Beneficiaries who aren’t related to you will pay the highest rates. Gifts to spouses are generally exempt. 

Twelve states and the District of Columbia impose their own estate taxes as of 2019:

  • Washington
  • Oregon
  • Minnesota
  • Illinois
  • New York
  • Vermont
  • Maine
  • Massachusetts
  • Rhode Island
  • Connecticut
  • Maryland
  • Hawaii

Tennessee, New Jersey, and Delaware repealed their estate taxes as of 2018. 

Estate tax exemptions at the state level tend to be much less than the $11.58 million federal exemption. It’s just $1 million in Oregon and Massachusetts—something to keep in mind when you’re weighing the benefits of living trusts and gifting as you plan your estate. Irrevocable trusts shield against state taxes as well.

Estate planning for tax purposes involves many interlocking pieces. You might want to consult with a tax professional to make sure you’re going about it in just the right way if you’re bequeathing significant property. 

NOTE: Tax laws can change periodically and the above information may not reflect the most recent changes. Please consult with a tax professional for the most up-to-date advice. The information contained in this article is not intended as tax advice and it is not a substitute for tax advice.

Article Sources

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  4. IRS. "Frequently Asked Questions on Gift Taxes." Accessed June 19, 2020.

  5. IRS. "Retirement Topics - Beneficiary." Accessed June 19, 2020.

  6. American Bar Association. "Estate, Gift, and GST Taxes." Accessed June 19, 2020.

  7. IRS. "Frequently Asked Questions on Gift Taxes for Nonresidents not Citizens of the United States." Accessed June 19, 2020.