You may have heard that one of the main reasons to establish a living trust is to reduce your tax liability. But what does this really mean?
Your estate is made up of all of your assets - real property, bank accounts, investments, retirement plans, insurance policies, and tangible personal property (e.g., jewelry, clothing, furniture, artwork, automobiles, etc.). Currently, the federal estate and gift tax exemption is $5.45 million per individual, or $10.9 million for a married couple. This means that these amounts can be left to heirs without owing any federal estate or gift taxes. After that, the tax rate is high - 40% - which means that if an individual (or couple) transfers more than $5.45 million (or $10.9 million) either during life or after death, this balance will be taxed at 40 percent.
According to the IRS, gifts given to a recipient while you’re alive are also subject to a gift tax at the same rate as the estate tax - 40%. However, you do not have to pay this gift tax on anything less than the annual exclusion limit, which is currently set at $14,000 ($28,000 for a married couple) per recipient. In other words, you could give up to $14,000/$28,000 to each of your children each year without anyone ever having to pay a gift tax. If you give an individual more than $14,000/$28,000 during the course of a year, you must report the gift to the IRS by filing a gift tax return, and any amount given over this annual exclusion limit will be counted towards the lifetime tax exclusion for gifts, currently $5.45 million. If this number sounds familiar, it’s because this $5.45 million exemption applies to both gifts and estates, combined. So whatever exemption you use for gifting will reduce the amount you can use for the estate tax. In other words, each dollar of gift above the $14,000/$28,000 threshold reduces the amount that can be transferred tax-free in your estate.
For example, if one year, you give your child $1.014 million, then you won't pay the gift tax on $14k, per the annual gift exclusion. In addition, you won't pay any additional gift tax, but the total you are exempted from taxation upon your death is now $4.45 million (5.45 million, less the $1 million - the gift amount less the $14k annual exclusion) you gifted while you were alive.
For married couples, it is important to remember that spouses can leave any amount of property to their spouses, provided the spouses are U.S. citizens, free of federal estate tax. The estate tax exemption is “portable” between spouses. This means that if the first spouse dies without using all of his or her $5.45 million exemption, the surviving spouse’s estate can use any amount not used by the first spouse’s estate. For example, if the first spouse to die passes on $2 million, his or her estate will not be taxed and the surviving spouse can then pass on $8.9 million free of federal tax ($5.45 million plus the unused $3.45 exclusion from the first spouse).
While most individuals might think their estates will never exceed the estate tax exemption amounts, it is very possible the amount could change in your lifetime and assets such as life insurance policies and real estate do add up. No matter what your assets are, it is always a good idea to consult an attorney or financial advisor to ensure that you are making smart decisions when it comes to gifting and planning your estate.
Disclaimer: This is not intended to be legal or tax advice, but rather general principles of the current tax law that show the importance of planning your estate.