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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Not all “death taxes” are the same. Estate taxes are imposed on the overall value of an estate—everything a decedent owns at the time of his death. Inheritance taxes, on the other hand, are levied against each individual bequest made from an estate to a beneficiary.

Yes, this means gifts can be taxed twice, but not at the federal level because the Internal Revenue Service doesn’t impose an inheritance tax. Neither does it tax inheritances as income. 

A few states do tax inheritances, however, so you’ll want to both minimize the tax burden on your estate and protect your beneficiaries against any income tax implications or possible state inheritance tax liability. 

Not All 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.

This is moot for many individuals because as of 2018, an estate’s value must exceed $11.18 million before the balance is subject to estate taxes at the federal level.

You’d have to be pretty wealthy before you’d have to deal with this issue in the first place. But if you do, a revocable living trust—the most common kind—won’t do you any good.

The term “revocable” says it all. As the trustmaker, you can undo your trust at any time. You can dissolve it, take the property back out of its ownership, or change its beneficiaries. Any income generated by this type of trust is reported and taxed on your personal return. You still legally own all the assets you fund into the trust, and as such, the IRS says it still contributes to your estate for estate tax purposes.

This isn’t the case with irrevocable trusts. The trustmaker must step aside when she creates one of these trusts. She can’t act as trustee as she can with a revocable trust, maintaining control so she can change things up over the years as she sees fit. She must appoint a third party to act as trustee. 

She gives up ownership of the property and assets that she funds into it. And if she no longer owns it, it’s not included in her estate for estate tax purposes when she 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 deal with them in the first place. 

It’s Better to Give Than Receive 

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

But you might 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. 

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

What happens if you go over $15,000 per person per year? You can subtract the overage from your $11.18 million estate tax exemption, but it will leave less of the exemption to cover your estate when you die. 

Valuation Dates: Give Now or Give Later?

Now that you’ve planned your estate for tax purposes, it’s time to address how their inheritances will affect your beneficiaries. Although their gifts themselves aren't usually taxable to them as income, this doesn’t necessarily mean that the IRS won’t have its hand out for other types 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 bought a home of her own, however. She doesn’t want to sell and move back into your home, nor does she want to rent it out and deal with being a landlord. She decides to sell it.

Capital gains tax is normally payable on the difference between an asset’s cost 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 $11.18 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. That’s a lot of capital gains tax.

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 and she immediately sells the property for $400,000. Cost basis is “stepped up” to date-of-death value for inheritances. If the property was worth $400,000 on the date of your death and she sells it for that amount, she hasn’t realized a gain. If she hangs on to the property for a year or two and ultimately sells it for $425,000, she would have a $25,000 gain. 

Of course, we’re talking taxes here, so there’s always a catch. 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 home in this case. This would favor your beneficiary if the property increases slightly in value during that time. The cost basis remains the value at the date of your death, however, if your estate doesn’t owe an estate tax.

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

Inheriting a Retirement Account 

Retirement accounts can be tricky inheritances for your beneficiaries as well. 

Distributions from these accounts are generally taxable, and if you leave your accounts to anyone other than your spouse, tax law is pretty strict about when distributions must be taken. Your 30-year-old son won’t be able to just sit on the account for 35 years until his retirement, letting it grow and 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, she can simply take it over. She wouldn’t have to begin taking required minimum distributions and paying taxes on those distributions until she reaches age 70½, just as if she had personally owned the account all long. 

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 2018: 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 these states 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 2018: Washington, Oregon, Minnesota, Illinois, New York, Vermont, Maine, Massachusetts, Rhode Island, Connecticut, Maryland, and Hawaii. Tennessee, New Jersey, and Delaware have all repealed their estate taxes as of 2018. 

Estate tax exemptions at the state level tend to be much less than the $11.18 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. 

Tax laws 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.