Creating a comprehensive estate plan requires you to take a number of factors into consideration. One of the most important of those factors is the impact state and federal taxes could have on your estate plan. You may be familiar with the concept of federal gift and estate taxes; however, you may not be certain if the federal gift tax applies to your estate and, if so, how it will affect your estate. Failing to understand how federal (and state) gift and estate taxes work and the impact they can have on an estate can be a fatal flaw in your estate planning efforts that could lead to the loss of a significant portion of your estate’s value. The best way to ensure that you have accounted for the impact of gift taxes on your estate plan is to work with an experienced California estate planning attorney at all times; however, a brief overview of the estate and gift tax rules may also be beneficial to you.
What Is the Federal Estate and Gift Tax?
The federal estate and gift tax is a tax imposed by the U.S. federal government on the transfer of wealth, whether that transfer is accomplished during a taxpayer’s lifetime or at the time of death. The tax is paid when your estate is probated after your death. Gift and estate taxes are computed by first adding the value of all qualifying gifts made during your lifetime to the value of the estate you left behind at the time of your death. That total is then potentially subject to the federal estate and gift tax at the rate of 40 percent. For example, if you made lifetime gifts of $2 million, and owned assets valued at $5 million at the time of your death, you would have $7 million that is potentially subject to federal estate and gift taxation. Without any further adjustments, deductions, or exclusions, your estate would lose $2.8 million in taxes.
What Is the Lifetime Exemption?
The good news is that each taxpayer is entitled to deduct from their estate the current lifetime exemption amount before federal gift and estate taxes are calculated. Historically, the lifetime exemption amount was subject to change – and did fluctuate – on a yearly basis. The American Taxpayer Relief Act of 2012 (ATRA) permanently fixed the lifetime exemption amount at $5 million, to be adjusted annually for inflation. For 2016, the lifetime exemption amount is $5.45 million. Therefore, only assets valued above the current lifetime exemption limit will be taxed. In our example above, we would deduct the $5.45 million from $7 million, leaving $1.55 million subject to federal gift and estate taxes. Your estate would then owe $620,000 in taxes instead of $2.8 million.
Can’t I Rely on the Unlimited Marital Deduction?
The unlimited marital deduction allows a married taxpayer to leave a spouse an unlimited amount of assets tax-free. While this can work to avoid taxation on your estate, it often over-funds a spouse’s estate, effectively just prolonging the inevitable payment of taxes. In addition, the unlimited marital deduction only applies if your spouse is a U.S. citizen. If your spouse is a foreign national, you cannot use the marital deduction.
How Does the Yearly Exclusion Work?
One commonly used tax avoidance strategy for taxpayers with moderate to large estates is to make use of the yearly exclusion. The exclusion allows you to make gifts valued at up to $14,000 each year to an unlimited number of beneficiaries tax-free. Not only are these gifts tax-free, but they do not count toward your lifetime exemption limit. If you are married, you may also use the “gift-splitting” option to make combined gifts valued at up to $28,000 each year. If you and your spouse have two adult children and you max out your exclusion each year for ten years with both beneficiaries, you could transfer $560,000 tax-free. In the above example, that would bring your taxable estate down to just $990,000 and your tax liability to $396,000, saving you over $200,000 in federal gift and estate taxes.
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