Minimizing Estate Taxes: Gifting to Heirs
In the first decade of the new millennium, many Americans escaped the grip of estate and gift taxes as the government raised the amount of money you could leave without owing taxes. Now, if your property totals less than $5.45 million you are not subject to federal estate taxes. (This number increases with inflation.)
However, there are fifteen states (and also the District of Columbia) that impose state-level estate taxes, many at lower limits than the federal. New Jersey is the least generous, exempting only the first $675,000 from estate taxes. New York State taxes every dollar of your estate if it exceeds the threshold (currently $4.1875 million).
Estate taxes can be very steep. The top federal estate tax rate is 40%, and if you live in New York State, you will have to pay a top 16% state tax rate on top of that. (The state tax is a deduction from the federal tax, so the combined top tax rate is 49.6%.)
Given tax rates this high, it can be useful to shrink your estate in ways that accomplish your legacy goals. One such strategy is gifting to charity, either in your will or before you die. Here, however, we will discuss making gifts to your intended heirs before you pass away.
Why lifetime gifting can reduce your estate tax burden
Compare two scenarios for someone who would be subject to the maximum federal estate tax rate. First, let’s say she wants to bequeath $1,000 (above the exemption amount). Her estate will have to have $1,666.67: After subtracting the 40% estate tax bill from $1,666.67, $1,000 will remain for the heirs.
Suppose instead that this wealthy and generous person decided to give away $1,000 while she still lives. There is no gift tax on the first $14,000 that an individual gives to any recipient, so no tax would be due at all--the same $1,666.67 in disposable cash would actually allow the intended heirs to get that full amount, rather than just $1,000.
Let’s suppose further that our generous benefactor has used up her $14,000 gift tax exemption per recipient. Her heirs are still better off receiving the gift during the benefactor’s lifetime: At the same 40% top federal gift tax rate, she were to give away $1,000 she would also have to pay 40% of that amount, $400, to the government.
By giving while alive, she would be able to transfer the same $1,000 for a total cost of $1,400 rather than $1,666.67. If she still wants to divest herself of the full $1,666.67 then she can give away $1,190.47 and pay a tax bill of $476.19.
The reason for the difference is that there is no tax levied on funds you pay to the government as gift taxes. But your entire estate is taxed, even that fraction of it that is used to pay estate taxes.
Married couples can get double exemptions
If you are married, both you and your spouse have the same exemptions: Each of you can give $14,000 per year to each recipient. Each of you can get a federal estate and/or gift tax exemption of $5.45 million.
State tax laws likewise double the available exemptions for married couples. But you have to be careful, because in some ways state tax laws differ from the federal. For example, under federal law the first spouse to die can transfer his/her unused estate tax exemption to the surviving spouse. (This requires filing an estate tax return even if no tax is due.)
On the other hand, in New York State, spouses cannot transfer their unused exemptions. A couple with more than the current $4.1875 million exemption amount who wants to minimize their state tax burden would have to title some assets in each spouse’s name and could not leave their entire combined assets to the surviving spouse.
What counts as a gift?
If you are not the parent or legal guardian of a child, paying room and board for that child’s college counts as a gift and could be taxable. So could paying other expenses such as buying a car.
On the other hand, paying for medical care or college tuition directly to the providers does not incur a gift tax liability. (Giving money to a child that is then used for college tuition does not escape the gift tax.)
Without significant financial aid, private college costs more each year than the annual gift tax exclusion. One way to get around paying gift taxes is to set up a 529 plan for the benefit of a future college student.
Gifts to a 529 plan are treated the same as other gifts, but can be used for a variety of educational expenses, not just tuition. So, for example, you could contribute up to $14,000 each year to your grandchild’s 529 plan in the years before college and owe no gift tax.
Then when your grandchild is in college, he can use the accumulated savings in the 529 plan to pay for room and board. In addition, you can pay the college tuition directly if needed. In this way, with advance planning you can pay the entire cost of your grandchild’s college without owing any gift taxes.
Income tax consequences for unrealized capital gains
When you die with an asset in a taxable account on which there are unrealized capital gains, the government basically forgives the capital gains taxes that would be due on selling that asset. This is called the “step up in cost basis.” (There is no step up in cost basis for IRAs or tax-deferred annuities.)
However, when you give an asset as a gift, you also give its cost basis. So if the recipient of your generosity decides to sell the asset, he must pay any capital gains taxes that are due based on what you originally paid for the asset.
Even worse, the embedded tax liability does not reduce the value of the gift. So, for example, if you give $1 million in stock with a $500,000 cost basis, you have to pay gift taxes on the full $1 million. But if your giftee sells that stock, he will owe capital gains on the $500,000 profits (at least $119,000 in federal taxes plus state taxes), leaving him only $881,000 at most.
Income tax consequences for unrealized capital losses
The flip side of the step up on cost basis is that if you have unrealized losses on an asset, you and your heirs lose the potential tax benefit of those losses when you die. So it would make sense to gift assets on which you have unrealized losses, especially if the intended recipient is in a tax situation where he is more likely than you to be able to benefit from a tax loss.
Tax-deferred assets cannot be given as gifts
You cannot give away your retirement accounts, so it is up to you to optimize the tax consequences for yourself and for your heirs. Retirement accounts such as IRAs are great for your own retirement but can lose most of their value as bequests.
The reason is that, unlike the case with an appreciated asset in a taxable account, the government will collect both income taxes and estate taxes due on the retirement account.
For example, suppose that in addition to more than $5.45 million in other assets you have $100,000 in a traditional IRA. Your heirs will have to pay the full $40,000 in inheritance taxes on the IRA.
In addition, they will have to pay the unpaid income taxes on the $100,000 which can be as high as $43,400 at the federal level, not counting any state income taxes that would also be due.
It is some relief that the two tax bills do not simply add up. Rather, the estate tax paid is a miscellaneous itemized deduction against the income tax due.
Even so, in the top tax bracket in a high-tax state such as New York, the various governments end up taking 75 cents on the dollar on inherited retirement accounts. Note, however, that if your estate is below the federal threshold of $5.45 million then this is much less of an issue.
What can you do about this? Some wealthy people bequeath their traditional IRAs to charities or charitable trusts. In this case, the charity would get the full amount with no loss to either income or estate taxes.
If your estate is close to the threshold for owing estate taxes then another alternative is to reduce your estate. If you have a valued charity, you can make a gift to reduce your estate to below the estate tax threshold. (There would be income tax savings too.)
This is especially important in New York State, where your estate is just $1 above the threshold then the entire estate is taxed. (Most jurisdictions tax only the amount above the threshold.)
Reducing your estate to below the estate tax threshold is one example where converting to a Roth IRA can be helpful. If paying the taxes due on a Roth conversion gets your estate below the estate tax threshold, your heirs will end up with more money than if they inherited and liquidated traditional IRA accounts. The reason is the funds you use to pay the income taxes due on a Roth conversion will not be subject to estate taxes.
As with an inherited traditional IRA, non-spouse heirs must take distributions from inherited Roth IRAs. But there are no income taxes due on those distributions. So inheriting a Roth IRA is even better than inheriting cash because any investment gains that an heir earns within that IRA are not subject to income tax.
Note that a Roth conversion to reduce estate taxes can be a bad idea if you are in a higher tax bracket than your heirs. You should perform careful tax projections before making any decision that will incur a major tax liability.
One final point: Spouses can inherit traditional or Roth IRA accounts without owing any taxes on the transfer. IRA accounts cannot be given as a gift.