Leaving the greatest gift of all: A tax-reduced estate

We’re in December, and my email is buzzing with routine year-end financial matters, many of which are related to tax and estate planning. As you can imagine, these two topics often converge, especially when I’m asked about the best strategies for leaving a tax-reduced estate to ensure that loved ones inherit the maximum possible assets. Minimizing the tax burden and avoiding the potential complications of settling an estate are certainly worthy goals to aim for! In this blog, we’ll delve into effective methods to achieve a tax-reduced estate.

The Basics: Understanding how you or your heirs may be taxed

It’s crucial to grasp that a variety of taxes come into play when outlining a tax-efficient estate. These may come into play during your lifetime, trigger at your passing, or be paid by your beneficiaries. I’ll broadly focus on these four: 

• Federal Estate Tax
• State Estate Tax
• Income Tax
• Gains Tax

Reducing what your heirs will pay for Estate Tax

Federal and state estate tax trigger at your passing. For most, federal estate tax isn’t a concern unless, as an unmarried individual, your estate exceeds $13,610,000 (the exclusion amount for 2024). If married, the surviving spouse typically inherits the deceased’s assets with no estate tax due. By filing a simple form, the surviving spouse also inherits the deceased’s federal estate tax exemption. This means, at the survivor’s eventual passing, beneficiaries can use both exemptions to reduce the taxable estate. If both parents pass in 2024, they could collectively have a $27,660,000 exemption, a figure most can only dream of.

Nevertheless, estate taxes remain a concern for those well below that net worth for two reasons. First, in 2026, the exemption is likely to halve with the expiration of the Tax Cuts and Jobs Act. Secondly, the amounts exceeding the exemption are taxed up to 40%, a significant rate! Given the high tax rate and the political influence on exemption amounts, exposure to federal estate taxes is a scenario many fear.

State estate taxes vary based on residence. Some states impose no estate tax, like New Hampshire and Florida. Others, like here in Massachusetts, have their own tax schedules. In MA, an individual’s estate over $2,000,000 is taxed up to 16% and it’s not easy to transfer it to the surviving spouse. $2,000,000 may seem like a lot, but when you consider home values, it adds up faster than expected. As a joke, I like to say that friends don’t let friends die in Massachusetts! It is possible to preserve the deceased spouse’s exemption with a bypass trust, but this is often a missed opportunity. For more on MA state estate taxes, read here.

How do you address estate taxes of either variety?

I suggest starting early and updating regularly. Reacting to an impending estate tax is challenging. However, a proactive strategy that can be adjusted over time is the most efficient way of transferring tax-deferred or tax-free wealth from one generation to the next. Remember, the name of the game for lower estate taxes is to have an overall smaller estate that reduces or avoids the tax entirely.

Gifting

One effective method is utilizing annual exclusion gifts ($17,000/year from any one person to another in 2024). These gifts don’t need to be reported to the IRS and can significantly reduce your taxable estate. The gift could be cash or in other forms, like Roth contributions for a child or grandchild (assuming they qualify), maximizing the tax-reduced benefit as Roths grow tax-free..

College Funding

Another key aspect of planning for a tax-reduced estate is college funding. This is where the potential of a 529 plan comes into play. In 2024, for instance, you have the ability to make a 5-year upfront lump gift of $85,000 per individual into a 529 plan – and that’s $170,000 for couples. Despite concerns about overstuffing these plans, which generally have caps around $350-450k, they are, in my experience, significantly underutilized in terms of wealth transfer.

What’s more, the scope of these 529 plans extends beyond college tuition. They can now be used for K-12 private education and even for post-graduate studies. Think about the possibilities here: any remaining funds in these plans can be strategically maneuvered – rolled over into the beneficiary’s Roth IRAs, used to offset student loans, or even transferred to another related beneficiary. The idea of maximally funding a 529 plan for your child, thereby allowing any surplus to grow tax-deferred for a grandchild’s benefit, is a powerful tactic in reducing your taxable estate while bolstering your family’s educational future.

For those with children or grandchildren currently enrolled in college, consider this: you can directly pay their tuition bills. This method doesn’t count against your annual gifting exclusion, thus allowing a more accelerated reduction of your estate. This direct payment strategy applies to medical expenses as well, offering another avenue to efficiently manage your estate’s size. The key is to pay the bills directly.

Trusts

Lastly, a strategy you’re likely quite familiar with in the pursuit of a tax-reduced estate is the direct gifting of assets to heirs or placing them into an irrevocable trust. This method effectively removes these assets from your estate. It’s true, these larger gifts need to be reported to the IRS, but here’s the catch – they aren’t taxable unless they exceed the lifetime gifting exclusion, which aligns with the federal exemption limits. The IRS’s role here is more about keeping tabs on these gifts against your lifetime exclusion, rather than taxing you upfront.

Take, for example, gifting your family vacation property into a trust. This action not only extracts its value from your tax-reduced estate but also potentially safeguards it from Medicaid scrutiny. It also clearly outlines how the next generation can manage and benefit from this asset. And don’t worry – this doesn’t mean you lose out on enjoying the property. In most cases, you can continue using it just as before, as the intent often isn’t to sell but to preserve and pass it on.

However, it’s crucial to consider the implications of such gifting on what’s known as the step-up in basis at your time of death. This aspect can be a double-edged sword in estate planning. While you reduce your estate taxes through these gifts, you might also be forfeiting the step-up in basis benefits. This balancing act of evaluating one tax impact against another varies with each situation and often requires an informed prediction of future tax rates.

In essence, gifting assets or moving them to a trust forms a cornerstone in shaping a tax-reduced estate. Yet, it demands a nuanced understanding of its benefits and potential trade-offs, tailored to your specific financial landscape.

Income Taxes

With estate tax, we’re aiming to reduce taxes due at our death. With income taxes, we’re focused on paying the least tax while we’re alive with the intention of more being amassed to pass along. However, deciding on the most tax efficient strategy really requires a discussion about the beneficiaries finances – which may feel uncomfortable or intrusive to bring up. But without this conversation, it’s hard making a good decision on what assets to pass along to the next generation without knowing the next generation’s tax situation compared to your own. This missed step can be the undoing of passing along a tax-reduced estate. 

For instance, considering who should pay taxes on retirement distributions is crucial. If your income is higher and your child’s lower, it might be more tax-efficient to leave them the IRA. Conversely, with lower income and expected significant medical expenses, using retirement funds yourself and leaving non-retirement assets could be advantageous.

Ultimately, deciding on what should be left for inheritance from the stance of income taxes needs to be planned year-to-year with all relevant parties considered.

Optimizing Accounts for a Tax-Reduced Estate

Along the lines of which accounts to spend down vs preserve for inheritance, generally speaking, Roth accounts are ideal to leave as a “last-tapped” asset because it can be transferred tax-free to the next generation. Of course you’ll have to consider your cash flow and income tax situation to make this decision. But that aside, a Roth is a great account to help fund or leave as an inheritance.

The same is true for whole-life policies. Keeping your hands off the cash value so the policy can remain in force until your passing means the death benefit will be inherited as a tax-free asset. And potentially accounts, stock, or property with huge gains make sense to leave as an inheritance (read on to learn why).

Gains Taxes

Retirement account distributions are taxed as income, whether from growth or original contributions. In contrast, non-retirement accounts and property are taxed only on their growth. Assets held for over a year qualify for long-term growth taxation, generally more favorable than income tax rates. For instance, selling a vacation home bought for $150k at $750k results in a 20% tax on the $600k gain. However, if you own the property at death, it receives a step-up in basis, potentially eliminating gains tax for you and your heirs. If heirs sell soon after inheriting, the new basis, reflecting the property’s value at death, likely matches or approximates the sale price, effectively avoiding the tax.

In certain estates with low-basis assets like property or stock, it’s often advantageous to retain these until death to bypass gains tax. To continue the earlier example, placing a home bought for $150k in a trust removes it from the estate, but the original $150k cost basis transfers to the trust. When heirs eventually sell, they pay tax on the increase from $150k to the sale price. While this strategy may save on estate tax by excluding the property from the estate, it forfeits the step-up in basis benefit.

Conclusion

Leaving a tax-reduced estate requires meticulous planning and a proactive approach. Understanding the complexities of various taxes and implementing strategic measures can help preserve wealth for future generations. By evaluating your financial situation and creating a tax strategy, you can ensure that your loved ones benefit maximally from your efforts.

If you’re looking to navigate these intricate financial waters and want to create a plan that best suits your needs, I invite you to book a consultation with me, Quentara of Powwow LLC. Together, we can explore all your options and devise a personalized strategy that maximizes the benefits of a tax-reduced estate for you and your loved ones. Don’t miss this opportunity to secure your financial future – reach out today to start your journey towards effective estate planning.