One of the primary concerns when you create your comprehensive estate plan should be the impact federal gift and estate tax will have on the estate you leave behind. Without careful planning, your estate could lose a significant percent of its assets to taxes. Every dollar your estate loses to federal gift and estate taxes is one less dollar that will be available to provide for your loved ones in your absence. Creating an estate plan that is focused on reducing your estate’s exposure to taxes, however, requires an understanding of how and when the federal gift and estate tax applies to your estate. Because every estate is unique, and tax laws are subject to change at any time, it is always in your best interest to consult with an experienced North Dakota estate planning attorney to determine how gift and estate taxes could impact your specific estate; however, an overall understanding of the tax is a good place to start.
What Happens to Your Assets When You Die?
When someone dies, his or her estate is usually required to go through the legal process known as probate. Probate has several purposes, including:
- Ensuring that all estate assets are identified, located, and valued as of the date of death
- Allowing creditors of the estate to file claims against the estate
- Providing a method by which Uncle Sam is assured of payment for any federal gift and estate tax owed by estate.
- Making sure that the remaining estate assets are transferred to the intended beneficiaries and/or heirs of the estate.
What Is the Federal Gift and Estate Tax an How Is Calculated
The federal gift and estate tax is essentially a tax on the transfer of wealth. The federal government wants to make sure that when wealth passes from one generation to the next it is properly taxed. The best way to do that is to tax the transfer at the time it occurs. Gift and estate taxes are potentially owed on the value of your estate assets owned at the time of your death combined with the value of all lifetime gifts made by your prior to your death. In other words, if you left behind an estate valued at $7 million and also made gifts throughout your lifetime valued at $3 million your estate would potentially owe gift and estate taxes on $10 million. Given the fact that the gift and estate tax rate is set at 40 percent, your estate would lose a whopping $4 million to the tax if that were the end of the considerations. Fortunately, it is not.
The Lifetime Exemption
Each taxpayer is entitled to exempt assets from gift and estate tax up to the current lifetime exemption limit. Historically this figure fluctuated frequently and significantly. Thanks to the American Taxpayer Relief Act (ATRA) of 2012, the lifetime exemption limit was permanently set at $5 million, adjusted annually for inflation. For 2016, the lifetime exemption limit is $5.45 million, meaning that a taxpayer can exempt up to that amount from his/her estate before gift and estate taxes are levied. In the example above, the first $5.45 million would be exempt, leaving a taxable estate of $4.55 million. Although the exemption certainly helps, your estate, and therefore your beneficiaries, would still stand to lose $1.82 million to Uncle Sam. This limit has increased in 2017 to $5.49 million.
The Annual Exclusion
While there are a number of estate planning tools and strategies that can be used to avoid, or at least reduce, estate taxes, one of the most common and easy to implement is the annual exclusion. Every taxpayer may make an unlimited number of tax-free gifts each year of assets valued at up to $14,000 using the annual exclusion. Moreover, the value of these gifts it not counted against your lifetime exemption limit. Gift splitting allows a married couple to combine their gifts to make gifts valued at up to $28,000. Again, using our example, let’s assume that you and you have four adult children and six grandchildren. Further assume that you started taking advantage of the annual exclusion 20 years prior to your death. You would have been able to transfer $140,000 each year over the 20 year period for a total of $2.8 million. Your taxable estate at the time of your death would then be down to $1.75 million which would incur a federal gift and estate tax obligation of just $700,000. Between the lifetime exemption and the annual exclusion alone you would have reduced your tax liability from $4 million to $700,000, effectively sheltering a total of $3.3 million more for your beneficiaries.
Please take a moment to download our free report “Should You Trust Your Estate Plan?” If you have additional questions about gift and estate tax, contact the experienced North Dakota estate planning attorneys at German Law Group by calling 701-738-0060 to schedule an appointment.