In calculating the financial resources that would be available to your family if something happened to you, don’t forget to take into account any estate or inheritance taxes, which can take a big bite out of any assets left to support your family. Death taxes can be levied at both the state and the federal level, so it’s important to look at your family’s exposure to each.
The Federal Estate Tax
Because the exemption to the federal estate tax has risen significantly in recent decades, the vast majority of Americans will never have to worry about it. (As I tell my clients, if you have to worry about the estate tax, that’s generally a good thing!) An estate tax is owed only if the value of a person’s estate exceeds the exemption amount, which is $5.45 million as of 2016. A 40% tax is imposed on any amounts over the $5.45 million exemption amount. For a married couple, each spouse is allocated a separate $5.45 million exemption, for a total family exemption of $10.9 million.
If you’re thinking you can just give away all of your assets over $5.45 million before you die to avoid the estate tax, the IRS is a step ahead of you. The federal estate tax works in conjunction with the federal gift tax, so that the $5.45 million exemption applies both to assets you give away during your life and those you leave at death. If you give away $2 million to your children during your life, then your remaining estate tax exemption will be $3.45 million.
One of the biggest traps for the estate tax, especially for young families, occurs where a person holds a large life insurance policy. If you have young children, you likely have a substantial life insurance policy, and the proceeds of that policy are included in the value of your estate. So, for example, if you have assets worth $3 million and you also have a $3 million life insurance policy, your estate will exceed the $5.45 million threshold, resulting in $260,000 estate tax liability.
Fortunately, if the federal estate tax is an issue for your family, there are many ways to reduce or even eliminate it through certain planning strategies if you plan ahead. Consult an estate planning lawyer to help you implement a plan to preserve your family’s wealth.
State Death Taxes
Depending on which state you live in, your state death taxes could be far more burdensome than the federal estate tax. State death taxes fall into two categories: estate taxes and inheritance taxes. Most states have either an estate tax or an inheritance tax, while some unlucky states like New Jersey have both. The difference between estate taxes and inheritance taxes is largely a matter of technicality. Estate taxes are collected from the estate itself, while inheritance taxes are imposed on the individual who inherits the assets. Inheritance tax rates often vary depending on the heir’s relationship to the person who died.
Because of the high federal estate tax exemption, many families who don’t have to pay federal estate taxes may have to pay state estate or inheritance taxes – to the tune of hundreds of thousands of dollars. Each state has different systems and rates of taxation, so make sure to look into your state’s rules to see how your family will be affected. Like the federal estate tax, many planning techniques can often substantially reduce or eliminate a state estate or inheritance tax, so consult an estate planning lawyer in your state to help you reduce your family’s tax burden.