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The last thing you want is to leave your loved one with a hefty tax bill upon your passing. Not only is this a liability, but it depletes the value of your estate. Do you want your hard-earned money to be spent on taxes, or would you rather your family was able to enjoy it?
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How Are Estates Taxed?
Estates are taxed at the fair market value of the assets, not the value you paid when you invested or bought the asset.
If you leave the assets to anyone but a spouse, your heirs may pay estate taxes on the higher value of the assets. If an heir accepts the inheritance, they will owe the taxes unless you take one of the steps below to lower the tax liability your heirs face.
According to the federal government, if your estate exceeds $11.7 million, it will incur federal taxes. Any amount that exceeds the $11.7 million threshold will be taxed at 40%, a hefty number, but with applicable deductions and credits, you can lower that amount considerably.
In addition, if you live in a state that taxes estates, your heirs will incur state taxes too. Today, the following states tax estates:
- District of Columbia
- Rhode Island
- New York
- New York
Most states tax at 10%, but it can get as high as 16% depending on where you live and the value of your estate.
Ways to Minimize Estate Taxes
1. Plan your deductions wisely
With the higher standard deduction, fewer taxpayers itemize their deductions. If you can strategize your deductions during years you’ll itemize, though, you’ll decrease your overall tax liability and increase your estate’s worth.
For example, if you know you’ll take the standard deduction this year, but next year you’ll have many more deductions, use that year to make large charitable contributions, take out a mortgage, or make a large IRA contribution.
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2. Put your assets in a trust
An irrevocable trust gives your estate the most protection. Not only can creditors not come after your estate, but the estate can’t be taxed if it’s in the trust. This means the assets in the trust don’t increase your estate’s value, which lowers your estate’s tax liability.
While the assets in the trust will be taxed at the trust’s tax rate, it will be much lower than the tax liability it would cause if it was a part of your estate.
3. Convert traditional retirement accounts to Roth retirement accounts
If your heirs inherit a large retirement account from you, they also inherit a large tax bill. Your heirs are responsible for all tax liabilities when withdrawing the funds from the retirement account.
If you convert to a Roth IRA or 401K before your death, you cover the tax liability when you convert. Don’t convert all your assets at once - that would trigger an incredible tax liability. Instead, strategically convert it, so you spread the liabilities out over several years. This way, your heirs receive a tax-free gift from you when you die.
4. Gift money while you’re alive
Sometimes it’s nice to see your loved ones enjoy the money you gave them. If you have liquid assets you can gift now that aren’t tied up in assets like your home or cars, you can gift up to $15,000 a year per person ($30,000 if you’re married filing jointly).
This does two things.
It brings the value of your estate down, so there’s a lower tax liability upon your death. It also gives your recipients a tax-free benefit since gifts up to the limit (it changes each year) are tax-free.
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5. Donate assets to charity
Charities take more than just cash. If you have assets you want to donate, you can transfer the assets to a charity. You don’t pay taxes on the capital gains because you didn’t sell the asset - you transferred it.
6. Donate Required Minimum Distributions to charity
If you’re over 72 years old, the IRS requires that you take an RMD (Required Minimum Distribution). You can donate some or all of it to charity, bypassing the tax liability and avoiding increasing your estate’s value. You can donate up to $100,000 of the RMDs per IRS rules.
7. Set up a Family Limited Partnership
If your family has large assets, such as properties or businesses, consider setting up a Family Limited Partnership. This means you set up a general partnership for when you’re alive and then make any beneficiaries or family members limited partners who take over when you die.
This keeps the property or business in the family even when you die but removes it from the estate since it automatically transfers to the other partners upon your passing. With a lower estate value, your estate will incur fewer taxes.
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8. Take out a life insurance policy
Typically, life insurance policies aren’t taxed, but if the value pushes your estate over the $11.7 million threshold, it can. One way to sidestep the issue is to have someone else own the policy. This means your name isn’t on it - even if you pay the bill by paying the owner, you're not the actual owner.
The policy will insure you but be owned by a beneficiary and will have named beneficiaries. This eliminates it from your estate and helps you limit your estate taxes.
The Bottom Line
Estate taxes take away from what your beneficiaries could earn, but there are many ways to decrease what they’d owe. Careful estate planning with taxation in mind will help your beneficiaries have more money in their pocket and less in the government’s hands.
If your estate is worth less than $11.7 million, you have less to worry about but should still use careful estate planning to ensure your beneficiaries get the most of your hard-earned estate.