7 minute read
Let’s talk about estate planning and gifting. To start we’ll explain what estate planning is beforewe go into some key taxes and estate planning and gifting strategies you should know about.
Estate planning, contrary to popular thought, is not just for the wealthy. Estate planning is often the best way for people to make sure their assets go to the intended recipient upon their death. It’s important for everyone to think about items such as wills, trusts, gifting strategies, educational accounts and business succession planning.
Estate planning, especially for the wealthy, is a great chance to minimize an estate being responsible for paying hefty estate or transfer taxes. Estate planning can encompass income, trust, estate, gift and transfer tax planning.
There are three main taxes to be aware of when it comes to estate planning:
There are several estate planning and gifting strategies. As mentioned above, there is the estate and gift tax. While they use different forms, these two taxes share the same exclusion amount during your lifetime.The exclusion is the amount allowed in each individual’s lifetime to be transferred without owing estate or gift tax.
Under current law, the exemption amount is $10 million adjusted annually for inflation. It will drop back down to $5 million adjusted annually for inflation in 2026. For 2022, the exemption is $12.06 million. The “unified credit” is the amount of credit applied against the first $12.06 million of assets.
There is also an annual exclusion, which is the amount of gifts that each taxpayer can give to an individual yearly without being required to reduce their lifetime exemption amounts or file a gift tax return (depending on the circumstances). For 2022, this amount is $16,000. It is adjusted annually for inflation but rounded up or down to the nearest $1,000.
Married individuals may elect to “gift-split” — meaning they can gift up to $32,000 to the same individual and it will be treated as if each spouse gifted $16,000. Gifts must be a “present interest” gift in order to qualify for the annual exclusion, meaning the recipient has the right to the money currently.
Future interest gifts do not qualify for the annual exclusion. An example of a future interest could be a gift to a trust that the beneficiary will receive distributions from in the future, but does not have the right to in the current year.
Over the years, a significant amount of assets can be shifted out of a taxable estate using only annual exclusion gifts. A popular strategy is to set up trusts for grandchildren that are funded with annual exclusion gifts through the years. This has the added benefit of allowing you to avoid the Generation-Skipping Transfer tax (discussed in greater detail below) as well.
Before moving on to more complicated strategies, always examine whether you’re taking full advantage of the annual exclusion.
Amounts that are gifted throughout an individual’s life are reported on federal form 709. Any amount not used during life may be applied to transfers of wealth upon death. After death, the full amount of assets gifted is added up and any transfers in excess of the exemption are subject to a 40% tax.
Form 709 is filed annually on or before April 15, and gifts over the annual exclusion amount must be reported. If one is electing to split gifts with a spouse, they must be reported and the election made regardless of the amount of the gift. Each year in which gifts are made over the annual exclusion amount, a running “tally” of each exemption amount used is made, including adjustments because of exemption increases or decreases. This is what is used to determine the amount of exemption left upon death.
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In the past, individuals could take advantage of a loophole to skip over their children and leave assets to the third generation (either grandchildren or anyone more than 35 years younger than them). Assets would be transferred to grandchildren without being subject to estate or gift tax upon the death of the second generation.
To combat this, the generation-skipping transfer (GST) tax was created. There is now a second “layer” of exemption — GST exemption. It is equal to the amount of the estate and gift tax exemption. Annual exclusion amounts can be made to “direct skips” without using the estate, gift, or GST exemption amount. While allocations of estate and gift tax exemption are mandatory, GST exemption allocations are optional.
There is also the trust income tax to consider. Trusts are subject to personal income tax rates with significantly compressed brackets. For 2022, trusts will be subject to the top tax rate of 37% after $13,450 of income.
Trust income is generally taxable when the income is not distributed to beneficiaries or the grantor. Some trust income may be distributed to beneficiaries while other income accumulates. Depending on the type of trust, the grantor (donor/funder) may be subject to income tax instead of the trust or the beneficiaries.
Trust income is reported and the tax calculated on the federal form 1041. Remember that trust income that is distributed out to beneficiaries is not typically taxed at the trust level, rather only income that is left to accumulate in the trust is taxed at the trust level.
There are other methods available to reduce a taxable estate. Direct payments of educational or medical payments are not considered gifts. Medical trusts (HEETs) may be set up to pay direct medical costs for grandchildren.
529 accounts may be set up and contributed to — this has no federal tax deduction but may have state tax benefits. Coverdell ESA contributions may also be made (but have low AGI limitations). Children with earned income can also have contributions to retirement accounts.
Several states also have a state-level estate or inheritance tax. An estate tax is levied against the decedent’s estate (the estate is taxed), while an inheritance tax is levied against the heir, so the heir is liable and pays rather than the estate.
There are 13 states that have an estate tax and 6 states that have an inheritance tax. Maryland has both an estate tax and an inheritance tax. Even if you are not a resident of the states, owning or inheriting property in these states can be enough to trigger a tax liability.
As mentioned above, basic strategies when it comes to estate planning and gifting include utilizing your lifetime exemption amounts, making direct payments, and maximizing annual exclusion gifts. Using these two strategies can save a lot of money in taxes. For a wider variety of tax planning strategies to get a holistic view of how much you could save, check out Corvee tax planning software, where you can automatically calculate thousands of strategy combinations with a click of a button.
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