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- Inheritance Tax vs Estate Tax
- 7 Ways to Lower Death Tax Expense
- What Is the Best Option?
There are two distinct taxes that are levied upon the assets of a person who has recently passed away. Because these taxes are paid on the assets of a deceased person, they are sometimes called “death taxes.” Death taxes refer to two distinct taxes: Inheritance Tax and Estate Tax. Even though both of these taxes target the assets of a deceased person, they have different tax rates and important exemptions that help people reduce their taxable amount or potentially avoid paying death taxes altogether.
Inheritance tax is a tax levied upon all the assets inherited by a person when the original owner dies. There is no inheritance tax set on a federal level, so every state sets its inheritance tax rate regardless of the other states. More specifically, only 6 states have an inheritance tax set in place while the majority of the states do not have an inheritance tax set in place. The following table provides the inheritance tax rate of the 6 states that have inheritance tax set in place:
|States That Have Inheritance Tax|
|State||Inheritance Tax Rate|
|Iowa||Up to 12%|
|Kentucky||Up to 16%|
|Maryland||Up to 10%|
|Nebraska||Up to 18%|
|New Jersey||Up to 16%|
|Pennsylvania||Up to 15%|
An estate tax that is levied upon the net worth of a person at the time of death. The estate tax is set on a federal level, so it applies to all states. The estate tax rate in the United States can be quite steep reaching up to 40% of the taxable amount. Even though estate tax can be pretty high, most people do not even come across this tax because of the tax exemption.
The estate tax in the US has a large tax exemption, which allows most people to pass down their assets tax-free. As of 2022, the estate tax exemption was set at $12,060,000. This means that all individuals with a net worth valued at less than $12,060,000 will not get taxed. For example, if a person’s net worth is $10,000,000, there will be no estate tax due because the amount is less than $12,060,000. On the other hand, if an inheritance is $13,060,000, then the beneficiary will have to pay tax on $1,000,000, which is a taxable amount in this case.
Once the exemption limit for estate tax is reached, it becomes progressive, similar to the structured income tax rate. The inheritance tax rate starts at 18% and quickly increases to 40% once the taxable amount reaches $1,000,000.
|Inheritance Tax Rates for 2022|
|Taxable Amount||Bracket Tax Rate|
|$0 – $10,000||18%|
|$10,001 – $20,000||20%|
|$20,001 – $40,000||22%|
|$40,001 – $60,000||24%|
|$60,001 – $80,000||26%|
|$80,001 – $100,000||28%|
|$100,001 – $150,000||30%|
|$150,001 – $250,000||32%|
|$250,001 – $500,000||34%|
|$500,001 – $750,000||37%|
|$750,001 – $1,000,000||39%|
Even though many individuals will never be taxed due to a high estate tax exemption and a low number of states that have an inheritance tax, it might still be important to understand ways to lower the taxable base and minimize tax expenses for the future. Luckily, there are ways to lower the taxable amount for both inheritance tax and estate tax, but it requires some planning and possibly working closely with a financial advisor before the death of the original owner. The techniques listed below may help a person reduce their taxable amount or potentially avoid paying inheritance tax altogether.
#1. Pass All Assets to a Spouse
If you live in one of the 6 states that have an inheritance tax, you can pass all the assets to your spouse tax-free. They will still be passed after death, but they will not be taxed with an inheritance tax because spouses are exempt from inheritance tax. It is important to note that it works only for inheritance tax. If the net worth of the individual is less than $12,060,000, then there will be no need to pay any taxes. On the other hand, if the net worth is more than $12,060,000, then the estate tax will have to be paid unless other ways to lower the taxable base are used.
#2. Move to a Different State
Inheritance tax is applicable only in 6 states, which means that there is a way to avoid paying inheritance tax by moving out of the state. It is important to understand how inheritance tax is levied before simply moving out of state and hoping it would be enough to avoid paying the tax. Inheritance tax is paid by the beneficiary, and it is paid on the assets of people who lived in the state where the tax is applicable. It is also important to note that some states may also tax assets located in the state even if the deceased person has not lived in the state.
A good way to avoid paying inheritance tax is to move to another state and sell all property and other assets that are tied to the state that has an inheritance tax. Once all the assets are located in a state that does not have an inheritance tax, it might be worth thinking about how to lower the taxable base for estate tax.
#3. Gift Assets to Family Members
It is also possible to pass down a considerable amount of wealth as gifts. The tax-free gift amount that can be gifted to another person is $16,000 for the year 2022. This limit also increases as the limit was only $15,000 for the year 2021. Every person also has a lifetime gift limit that they can give out without paying taxes.The lifetime gift exemption is $12,060,000, which means that a person can give $12,060,000 tax-free. It might be difficult to move millions of dollars in gifts at once, but this is a good way to lower your tax base before the estate tax is applied. If you have enough people, you may lower your tax base by as much as $12,060,000, which may be worth millions of dollars in savings.
This advice may not be useful for people who do not have a large net worth, but it is important to note that people who do not have a large net worth do not need to worry about paying estate tax since the tax exempts the first $12,060,000 of the net worth. On the other hand, if you hit a net worth of over $12,060,000, it may be worth distributing some of your money between the family members to avoid paying taxes on it later on.
#4. Set Up an Irrevocable Trust
There is a way to avoid estate tax completely, which is through setting up an irrevocable trust that will hold and potentially manage some assets. It is important to note that the estate tax is not applicable only if the deceased person does not get any benefit and has no power over the trust. An easy way to ensure that the person does not have any say in the trust is to create an irrevocable trust that does not allow any changes in beneficiaries after the original choice. In this case, the funds deposited into the trust are never accounted towards the estate tax. This happens because once the trust is set up, the asset holder transfers the ownership to another person with the trust. Since it is irrevocable, the beneficiary of the trust cannot be changed, so the proceeds will not be subject to estate tax.
#5. Purchase Life Insurance
Buying life insurance has its advantages and disadvantages. You can save money on taxes because of how life insurance works. Life insurance can be deducted from taxes, but it should not be purchased for the sole purpose of lowering the tax base. Instead, it should be considered as a safety net for the family members of the deceased. Buying life insurance may decrease the taxable base for the time the person is alive. On the other hand, once the person dies, the life insurance money will be counted towards the person’s estate and will be taxed accordingly. Only after the proceeds are taxed, can they be distributed among the beneficiaries.
It might be wise to include life insurance in the irrevocable trust discussed above. In that case, the holder of their life insurance gives it up and passes it to the irrevocable trust. Since the original holder of the insurance does not have the access to the irrevocable trust and the insurance, the life insurance proceeds, as well as other assets passed to the trust, will not be subject to estate tax.
#6. Set Up a Charitable Trust
Another way to lower the taxable amount for an estate tax is to give some money to charity. It may also provide tax breaks and other financial perks over the donor’s lifetime. Depending on what trust you open, the tax breaks you receive may be different. There are two types of charitable trusts worth discussing: Charitable Lead Trusts (CLTs) and Charitable Remainder Trusts (CRTs). So, both types of trust allow a person to protect their wealth against taxes in different ways.
Charitable Lead Trusts (CLTs) are irrevocable trusts that distribute income from assets held by the trusts to charities of choice. CLTs usually operate for a set amount of time, and once they stop operating, the assets from the trust are passed to the beneficiaries who are usually family members. This is a useful way to pass down long-term appreciating and income-producing assets because you can also receive tax breaks for charity donations and avoid estate tax on the assets held by the trust.
Charitable Remainder Trusts (CRTs) are similar to CLTs, but their structure is a little bit different. CRTs allow you to receive income from an asset that will be donated to charity once you pass away. In this case, the asset will not stay with a family member or an heir, but they will provide an estate tax deduction as well as capital gains tax breaks. Depending on what type of assets you have, you may want to weigh the pros and cons of both trusts before choosing the one that will provide the most benefit.
#7. Set Up a Limited Partnership
It is possible to avoid paying estate taxes by setting up a holding company that would hold a part of your assets while the heirs would be listed as limited partners. In that case, the holding company will be operating like a business and will have partners that share the profits of the company. Since the heirs are limited partners, you will still have the power to make decisions in the company. The ability to make decisions is one important feature that irrevocable trusts lack. Since the assets that are pledged to the partnership are not considered personal property, they will not be accounted for by the estate tax. A limited partnership may be a great option for people who would like to have access to their assets and to be able to manage their assets independently.
There are many ways to save money on death taxes. Depending on the circumstances, you may want to combine the multiple strategies described above. For example, if you have to pay inheritance and estate taxes, you may want to consider relocating as well as opening an irrevocable trust. On the other hand, if you want to manage your assets, you may want to open a limited partnership and call the shots. You can also do something good and save on taxes through charitable trusts. The best option depends on a specific financial situation, personal preference, and the types of assets pledged. It is also important to note that many of the options discussed above have a cost, so it is best to talk to a professional financial advisor before deciding how to avoid death taxes.