How the IRS Taxes Your Wealth & Estate

Last update on: Jun 22 2020
estate planning

If you’ve ever wanted to know how to reduce or even eliminate your estate tax…

It’s best to first understand how the IRS taxes your wealth.

Here’s the computation, in a nutshell:

Your Gross Estate…

Minus Deductions allowed (administrative expenses, funeral expenses, losses, debts, charitable contributions, marital deduction)

Equals Your Taxable Estate

Adding Lifetime Taxable Gifts You Made

Equals Your Tentative Tax Base

Applying The Estate and Gift Tax Tables

Equals Your Estate Tax

Subtracting Gift Taxes Paid During Your Lifetime

Equals Your Estate Tax Before Credits

Subtracting Your Unified Estate and Gift Tax Credit

Equals Your Estate Tax Payable

Adding Any Generation Skipping Tax

Equals Your Total Estate Tax Due

There used to a credit for state death taxes paid, but that was phased out.

To summarize the above outline, your executor compiles a list of all your assets and their values. That is your gross estate. Then various deductions are subtracted to arrive at your taxable estate.

Your lifetime taxable gifts are added to the taxable estate, because the estate and gift taxes are considered a uniform wealth transfer tax.

In other words, you should pay the same tax whether you give property away during your lifetime or after your death. Then the tentative tax on both your final estate and your lifetime gifts is computed. After computing the tentative tax, gift taxes paid during your lifetime are subtracted.

Next, the remaining tax is reduced by the amount of your estate and gift tax credit. Everyone gets an estate and gift tax credit. The amount of the credit is what changed the most from 2000-2012.

The current level of the credit is what exempts most estates from the federal estate tax. Note that since the estate and gift tax are unified, you can use all or part of the credit during your lifetime to make tax-free gifts, and that reduces the amount of credit available to your estate.

If you used all or part of the credit to reduce lifetime gift taxes, the amount of the credit that was used is not available to reduce estate taxes. There will be more details about the unified estate and gift tax credit later.

In the 2017 law, the lifetime estate tax credit was raised so it is worth up to $10 million per person. That amount is indexed for inflation and was set at $11.4 million for 2019. The maximum estate tax rate is 40%.

The generation skipping transfer tax also is extended with the same exemption and tax rate as the estate tax. The GSTT is the tax for gifts made directly to grandchildren and subsequent generations.

Because the credit for state estate and inheritance taxes was eliminated, people in states with those taxes need to pay attention to them. Before the credit was phased out, people didn’t worry about the state taxes.

The state tax credit reduced the federal tax due, so the federal credit was subsidizing the states that had the taxes. The estate paid the same total tax whether the state had the taxes or not. The only difference was the amount that was paid to the federal government.

Now, in some states there are estates that owe no federal estate tax but owe the state estate or inheritance tax.

There is an additional tax that might be added to the basic estate tax. The generation skipping tax is imposed when you try to pass assets directly to your grandchildren (or later generations).

Such a direct transfer would enable you to transfer wealth to your grandchildren without having it first taxed in your children’s estate.

There are a couple of points about the estate tax that often confuse people. As a shorthand, most discussions of estate planning say that $11.4 million of your estate is exempt from taxes in 2015. Actually, there is no exemption.

There is the unified estate and gift tax credit that has the effect of eliminating taxes on the first $11.4 million of assets. So $11.4 million is really the “estate tax exemption equivalent.”

It seems like a technical point. But it has a real effect if you made taxable gifts during your lifetime, because the estate and gift tax credit is used first against lifetime taxable gifts.

So if you made $11.4 million or more of taxable gifts during your lifetime, there will be no estate tax credit left for your estate.

You can see in the outline how the estate and gift taxes are unified. Your lifetime taxable gifts are added to the gross estate to determine the estate tax.

Then, the gift taxes you actually paid during your lifetime are subtracted from the tax payable. Finally, the remaining amount of your estate and gift tax credit is used to reduce the tax payable.

IN THE NEXT ISSUE OF RETIREMENT WATCH WEEKLY: Understanding the new “portability” rules that became permanent in the 2017 law — and how they affect you.

P.S. There are many strategies for estate tax reduction that the IRS will permit, and I’ll cover those in upcoming issues. In the meantime, a bombshell new report reveals how the IRS is now authorized to “raid” your retirement accounts… taxing up to 30% – or more – of your nest egg. Follow this link for my complete findings, and the #1 “sidestep strategy” I’m using in my own retirement plan.

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