Dianne Reis, attorney at law.

Board Certified - Estate Planning and Probate Law
Texas Board of Legal Specialization

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Questions Discussion
Why do I need a will?
Is probate really that bad?
Do I need a living trust?
Can my estate avoid paying an executor's fee?
How can I save estate taxes?
What is a bypass trust?
What is a life insurance trust?
What is a Crummey trust?
What is the difference between community property and separate property?
What taxes will the beneficiary of my life insurance policy have to pay?
What's the difference between an inheritance tax and an estate tax?
Who will get my property if I die without a will?

How can I save estate taxes?

Please remember that this answer is provided in the spirit of public education, not as legal advice. If you require legal advice for a particular situation, you should consult an attorney.

First, a bit of background on the federal estate tax.

The estate tax rate is now 35%. Your estate gets to take various deductions before applying this rate.

First, it gets a deduction equal to the amount of property or cash passing to your spouse. It also gets a deduction equal to the amount of property or cash passing to a qualified charity. In addition to both of those deductions, it gets what is effectively a $5 million standard exemption for all other property.

Each taxable gift you make during your lifetime uses up some of your estate tax exemption. If you make less than $5 million of taxable gifts during your life, the amount of taxable gifts you have made is simply added to your estate total when you die, and that's when you pay tax on them. If you make more than $5 million of taxable gifts, you have to start paying taxes on them during your life.

This system suggests two obvious ways to save estate taxes: Leave your entire estate to either your spouse or charity. But it also suggests a few more subtle ways, too.

1. Leave $5 million to a Bypass Trust, and the rest to your spouse.

If you leave everything to your spouse, you get a full marital deduction, but you may waste your $5 million exemption. (I say "may" because new legislation is meant to help preserve this exemption in some cases.  However, the legislation has limited application and will expire unless extended by Congress.)  By leaving the exemption amount to a trust designed to bypass your spouse's estate, you might save over a million dollars in estate taxes.

It works like this. Suppose a Husband and Wife have a joint net worth of $10 million. Husband dies first, leaving everything to Wife. Estate tax owed: zero, because of the marital deduction. Wife now owns $10 million. She dies under circumstances where her husband's exemption is not preserved, leaving her gross estate of $10 million to their children. Because of the $5 million exemption, her taxable estate is only $5 million. The tax on this is $1,750,000.

Suppose instead that Husband leaves $5 million to Wife, and $5 million to a trust that will pay all of its income to Wife as long as she lives, and then go to their children when she dies. Estate tax owed: still zero, because the marital deduction eliminates the tax on the first $5 million, and the standard exemption eliminates the tax on the second $5 million. The bypass trust is not considered to be owned by Wife at the time of her death, so her gross estate is only $5 million. After subtracting the standard exemption, her taxable estate is zero. Estate tax owed: zero. The bypass trust has saved them $1,750,000.

For more information, see my FAQ on Bypass Trusts.

2. Lifetime Gifts.

The first $13,000 of every gift you make to each person each year is excluded from your taxable gifts tally. Thus, if you and your spouse have three children, you could jointly make $78,000 in gifts to them each year, and these gifts will be completely excluded from your taxable estate. They won't even count against your estate tax exemption.

Even if they did count against your estate tax exemption, you might still want to make them in order to remove the future appreciation of the money from your estate. An example:

Suppose your spouse is deceased and you make a $23,000 gift to your son. This results in a $10,000 taxable gift being added to your taxable estate when you die. In the meantime, however, suppose your son invests the money (or you invest it for him through a trust arrangement) and it grows to $50,000 by the time you die. You have effectively transferred $50,000 of wealth to your son, but only $10,000 of it counts against your estate tax exemption. Also, unless you make taxable gifts totalling more than $5 million during your lifetime, you won't owe any gift tax.

For more information on trust arrangements for minors, see my FAQ on Crummey Trusts.

3. Life Insurance Trust.

Life insurance proceeds are included in your taxable estate if you "own" the policy. If you have the power to change the beneficiary designation, you are deemed to own the policy. If, however, you transfer the policy to a irrevocable trust with instructions to leave the beneficiary designation as is, after three years you will no longer be deemed to own the policy, and the proceeds will be entirely exempt from estate taxes. On a $300,000 policy, this will save $105,000 in estate taxes (assuming you have $5 million in other assets).

For more information, see my FAQ on Life Insurance Trusts.

Of course, there are other ways to save estate taxes. These are simply the most common and popular options.

 

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