Planning for what? Part Two-Federal and State Transfer Taxes

On Wednesday, I discussed one of the main objectives of any estate plan, the streamlining of the estate administration process.  For many, ensuring that assets pass in an expedited manner is the sole aim of their estate plan.  But, for people with larger estates, a second and sometimes more important goal is to minimize or eliminate the transfer taxes owed at their death.

Below is a brief explanation of the categories of transfer taxes related to estate planning.  One tax that is commonly discussed but not listed below is the “death tax.”  Despite the claims of many, there is no tax imposed at death simply due to the passing of an individual.  The following taxes are very real and require proper planning.

Federal Estate Tax.  The “death tax” typically refers to the federal estate tax.  In 2010, the federal estate tax was reinstated with a $5 exemption, meaning every individual can pass up to $5 million without incurring a tax (the exemption increases to $5.12 million in 2012).  Assets passing between spouses at death also pass free of estate tax due to the federal marital deduction.  In addition, married individuals who do no use their entire estate exemption may pass the remaining exemption to their spouse using a newly created concept known as portability.

The top federal estate tax rate is 35%.  However, absent action by Congress and the President before December 31, 2012, the exemption will be reduced to $1 million and the top tax rate will increase to 55% in 2013.

State Estate Tax.  Seventeen states and the District of Columbia also impose a state specific estate tax.  In the past, the state and federal estate taxes were linked, but due to the changes to the federal estate tax since 2001, most states have decoupled their estate taxes from the federal tax.

New York, New Jersey and Connecticut all have state estate taxes and New Jersey has an additional tax known as an inheritance tax.  In New York, the current exemption is only $1 million and is unlikely to be increased in the future.  Similar to the federal estate tax, assets passing to spouses pass estate tax-free.

While the tax rate is much lower than federal rate, it is still important for estates valued at or around $1 million to properly structure the estate plans to eliminate, reduce or delay payment of state estate tax.

Federal Gift Tax.  Transfers made to individuals other than a spouse during your lifetime are also subject to the federal gift tax.  There are two ways to avoid gift taxes on lifetime transfers.  First, you may use a portion of your lifetime gift tax exemption, which is currently $5 million (lifetime gifts reduce the amount of assets you can pass tax-free at death as the estate and gift exemptions are considered a “unified credit”).

The second way is by using an annual gift tax exclusion.  Each individual can gift up to $13,000 to as many individuals as they like each year without incurring a tax.  Married couples may combine their exclusions to gift up to $26,000 to each individual beneficiary.

The top tax rate for the federal gift tax is 35%, the same top rate for the federal estate tax.

Federal Generation Skipping Transfer (GST) Tax.  One of the more complicated taxes, the GST tax was created to prevent individuals from avoiding taxation by transferring assets to a descendant two generations or more removed from them.  Currently, the tax is imposed in three situations.  First, when a transfer is directly made to an individual two or generations below the transferor (a “skip person”).  Second, when there is a taxable termination of an interest by a non-skip person.  This typically involves a child with a life interest dying and their interest passing to a grandchild.  Finally, GST tax is imposed on distributions from a trust to a skip person that would otherwise non be subject to gift or estate tax.

The current federal GST exemption is $5 million with a top tax rate of 35%.  As with the federal gift and estate tax, the exemption will revert back to $1 million in 2013 absent action by the government.

Transfer taxes can create many problems for estates and significantly reduce their values.  Proper planning before an individual dies and proper administration after they die are essential to ensuring that the estate’s beneficiaries receive the largest possible portion of their loved one’s assets.

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