Understanding Estate Tax: Three Useful Concepts

By Brenden P. Melrose, CFP®, CIMA®, AIF®, Wealth Advisor at Halbert Hargrove

As the ever-quotable Ben Franklin said, “in this world nothing can be said to be certain, except death and taxes.” I’m going to discuss a combination of the two. Although estate tax may not ultimately affect you or your family, it’s important to know some basic concepts and implications to better understand how it could affect you.

But First, a Quick Review

Before we can talk about the concepts, it helps to have a basic understanding of federal gift tax and estate tax because they’re directly linked to each other.

Gift tax is a tax on your gifts of property to others – above a certain amount. Every year, the IRS sets the dollar amount that you can give to any, and as many, individuals as you want without owing any gift tax. It’s called the annual exclusion. In 2020, this exclusion is $15,000. If the total gifts given to any individual in a calendar year exceed that amount, the excess is considered a taxable gift. A gift tax return will need to be filed in every year you make a taxable gift. One big exception to this is if your gift is to your spouse. Gifts of any amount to spouses who are U.S. citizens are generally not considered taxable gifts.

But just because you’ve given a gift of more than $15,000 to someone other than your spouse in any given year doesn’t mean you have to pay a tax on it. No gift tax is actually due until the aggregate amount of your taxable gifts surpasses the lifetime gift tax exclusion – a dollar amount ($11.58M in 2020) that can be given away during your lifetime without having to pay tax.

For example, say someone wants to help a child make a down payment on a first home, and makes a gift to them of $100,000. Although the giver must file a gift tax return, no tax is owed to the IRS. If the gift is made in 2020, their lifetime gift tax exclusion will be reduced by $85,000 ($100k – the annual exclusion of $15k).

When a person passes away, their Gross Estate is calculated by adding up the fair market value of everything they own or have an interest in at that time. This could include cash and securities, trusts, real estate, etc. Then some debts, expenses, and certain deductions reduce that amount to arrive at their Taxable Estate. Taxable gifts made in that and prior years are then added to the Taxable Estate, and the tax is computed.

The Unified Exemption

Congress sets an estate tax exemption – a dollar amount  that is exempt from estate tax – for every given year. As mentioned above, that amount is $11.58M in 2020. Most people discuss estate tax using the exemption amount. But it’s a unified exemption because gift tax and estate tax share it.

When calculating estate tax, taxable gifts made since January 1, 1977 are added back into the estate valuation. This is the unifying aspect. You can make lifetime taxable gifts, transfer all your property at death, or some combination of the two. But in the end, they all get washed in together. If the value of your taxable estate combined with taxable gifts is less than the unified exemption, no estate tax is due.

Let’s go back to the fictional example above: John gave his daughter $100,000 to help with a down payment for a home in 2020. The annual exclusion amount was $15,000, which meant that John made a taxable gift of $85,000. Fast forward to John’s death later in 2020. The unified exemption amount is $11.58M. John’s taxable estate is valued at $11M. Assuming no other taxable gifts, no estate tax is due because the value of John’s taxable estate and taxable gifts is $11,085,000.

The unified exemption is subject to change with policy and law changes. It’s important to remain informed so you can know how you and your family may be affected. Advisors can help you decide effective ways to utilize the unified exemption, whether through lifetime taxable gifts, estate transfers, or a combination.

Portability

It’s not a Star Trek reference, nor does it indicate a wine’s ability to go well with dessert. Portability refers to an election that can be made by a decedent’s estate to pass any of the decedent’s unused unified exemption amount to the surviving spouse.

Let’s use another example: Mike and Mary are married when Mike passes away. In the year Mike died, the unified exemption amount was $5M. Since the value of Mike’s taxable estate and taxable gifts was $3.5M, no estate tax was due. There was an unused unified exemption of $1.5M. By electing portability, Mary could claim Mike’s unused unified exemption amount. This means when Mary passes away, her unified exemption will be increased by $1.5M. 

Before portability was introduced, an individual’s unified exemption was “use it or lose it.” This gave rise to estate planning structures that maximized utilization of an individual’s unified exemption.

With portability, a married individual’s unified exemption is no longer lost if unused. To claim portability, an estate tax return must be filed within nine months of the date of death. There is a six-month extension available. Portability has allowed many families to simplify their estate plans, as it allows for more flexible estate plan structures.

Federal vs. State Taxation

Most news or references you hear about estate taxes are probably at the federal level. Both concepts I’ve discussed apply on a federal level. While not many, there are about a dozen states that have their own estate tax, along with their own exemption amounts, which may be significantly lower than the federal unified exemption.

It’s important to understand the laws of the state where you live or plan to live in retirement, so you can plan accordingly. It’s especially important to revisit your estate plan if you move to a different state. The plan may have provided a great structure for both federal and state estate taxes before you moved – but have unintended negative consequences after the move.

As I mentioned in the beginning, having a basic understanding of estate tax is critical. Armed with this knowledge, and working with skilled estate planning advisors, you can make sure that your wealth is transferred as you intend. As Samuel Goldwyn said, “good luck is often with the man who doesn’t include it in his plans.”

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