Nobody likes taxes…well, nobody likes to pay taxes.  Many people might like the benefits that taxes provide, but nobody likes to pay the taxes.  I remember reading a fake news article (which I cannot find on the internet now!) where a man was surprised to learn his taxes were going up.  He said that he voted for all of the new parks, recreation centers, and school tax increases, but he was surprised to learn that his taxes were going up.  He was quoted as saying the tax increases were only supposed to affect the rich, not him. He wanted to reap the benefits of higher taxes, without paying any himself.

Obviously, we all want to pay as little tax as possible, and as legally allowed.  As my CPA friends say:

Tax avoidance is great, tax evasion is illegal!

Proper tax planning will look at the different types of taxes and how to reduce the necessary tax to be paid.  As stated above, nobody likes to pay taxes, and certainly nobody likes to pay more taxes than necessary. Tax planning is a necessary part of estate planning, as there are many types of taxes involved.

This blog discusses the three types of tax that need to be accounted for in your estate plan.

1. The Estate Tax is Probably Not Your Worry

Although it may seem to be the most obvious tax to be considered, estate tax probably will not apply to an estate.  The current estate tax limit for 2019 is $11.4 Million per person.  Since an estate tax exemption can be transferred between a married couple, the estate tax limit / exemption is $22.8 Million for a married couple.  This means that if someone has less than $11.4 Million, or $22.8 Million couple, they will not have any estate tax that is due.

2. Transfer Taxes – Gift Tax and Generation Skipping – How to Deal with These Two

Transfer taxes are connected to the $11.4 Million number.  A person is able to give away $11.4 Million either during their lifetime, or at the time of their death, before needing to pay gift tax.  The same is true of a generation skipping transfer tax – if you give more than $11.4 Million and skip a generation, like giving money to a grandchild instead of a child – then taxes could be due.  The lack of taxes due on a gift during life or death of less than $11.4 Million exists because of what is known as the Unified Tax Credit.  The Unified Tax Credit allows for a tax credit for gifts and transfers under the $11.4 Million amount, so that most gifts during a lifetime, or at death, are not taxable.

Any amount given away over that number is taxed at 40%.  For those who have over $11.4 Million in assets, there are estate planning techniques that can include gifting away assets that have reduced value because of restrictions on ownership, or other methods.  These techniques are part of a plan for a taxable estate, or an estate plan for those who have over $11.4 Million.

For those who have less than $11.4 Million, gift tax may be used to your advantage.  Many times those who are looking to qualify for government benefits, like Medicaid, or VA Aid and Attendance benefits, can give their assets away.  Such transfers are subject to restrictions, like lookback, or disqualifying, periods of 5 years for Medicaid, and 3 years for the VA, but the transfers are treated as gifts.  If a gift is less than $11.4 Million during a lifetime, then assets can be transferred without needing to pay tax.  This can be very helpful in planning to protect assets, but there are still more taxes to consider.

3. Income Tax – The Big One For Most of Us

This is where income tax comes into play.  Income taxes are always out there. When someone receives an inheritance, the inheritance is generally not considered income.  Instead, the tax that might be due on the payment to an heir or beneficiary is considered paid by the Unified Tax Credit, so inheritances received from someone with less than $11.4 Million are not taxes to the receiver.  In general, gifts and estates are taxed to the giver, not the receiver.

However, assets received by an heir or a beneficiary retain their tax attributes.  This means that different types of assets are treated differently. Most assets get what is known as a stepped up basis at the death of an asset owner.  This concept is related to how assets are taxes when they sell. If you sell a capital asset, the taxable portion of the sale, called taxable gain for income tax purposes, is calculated as sales price – cost basis, or what you paid for the asset.

An Example:

So, if you buy a house for $100,000, hold onto it for 30 years, and then sell the house for $400,000, your taxable portion of the sale is $400,000 – $100,000, or $300,000 of gain.  If you passed the same house on to your heirs at your death, then the heirs would have a cost basis of $400,000 in the house, the same value as the Fair Market Value at the time of your death, so that income tax would be calculated on $400,000 of sales price, minus $400,000 of cost basis, and $0 of taxable gain.

Watch out for Common Assets that are Treated Differently

Not all assets get a step up in basis.  Assets held in an annuity, or a tax qualified investment account like an IRA, Roth IRA, 401(k), 403(b) plan, or Thrift Savings plan, do not get a stepped up basis because of the favorable tax treatment that such investments received throughout someone’s lifetime.  So, when someone dies and transfers a qualified investment to their heirs, income taxes will still apply. An IRA can be paid out in different ways, either as a lump sum, or the IRS will allow a payout over 5 years, or the IRA can be rolled into an inherited IRA.

The lump sum payments and 5 year payouts are subject to income tax as a distribution, so income tax will be due on the money distributed, including a 10% penalty to the recipient if the recipient is under 59 ½ years old.  Transferring money into an inherited IRA allows the money to continue to receive the favorable tax treatment that the money received in the original IRA, but the transfer from the original IRA to the inherited IRA will not be taxed as a distribution.  Such tax planning needs to be carefully done, or a big tax bill may result if improperly set up.

Plan for Taxes in Your Estate Plan

Nobody wants to pay taxes, or more tax than is necessary.  I would much rather your money get where you want it to go, and not to the government, but making sure that happens is the product of careful planning.  Planning for estate tax, gift and transfer tax, and income tax is essential to a good estate plan. We can create a plan to make this happen. If you would like to discuss what would work best for you, please schedule an appointment here.