The federal estate tax is a tax on the value of property a decedent owned at the time of his or her death.
The tax is paid only by estates that exceed the exemption amount, which is $11.7 million for 2021. It is indexed for inflation each year.
Tax rates range from as low as 18% for estates within $10,000 of the exempt amount to as high as 40% for estates that exceed the exempt amount by $1 million.
The high tax rate is why many wealthy individuals use some of the many legitimate estate planning tools to reduce or completely avoid the federal estate tax. Below are just a few of the more popular ways to reduce or avoid federal estate tax.
Using an Irrevocable Life Insurance Trust
An irrevocable life insurance trust is one of the best and most common ways to avoid estate taxes. Creating an irrevocable life insurance trust avoids taxation on the benefits paid on a life insurance policy. Life insurance benefits are not subject to income taxes; however, they can be included in a person’s estate and be subject to estate taxes. The irrevocable life insurance can avoid those estate taxes.
After creating the irrevocable trust, the estate owner transfers assets to the trust that are used by the trustee to buy a permanent life insurance policy. The estate owner can transfer a lump sum amount that is used to buy a policy. Or annual transfers can be made that the trustee uses to pay annual premiums on the life insurance. There might be gift taxes due on the transfers to the trust, or the transfers might use part of the lifetime estate and gift tax exemption.
The assets in the trust aren’t included in the estate after he or she passes away if the trust truly is irrevocable and the estate owner didn’t have ownership rights to the life insurance or other assets in the trust. The insurance benefits are received by the trust free of income and estate taxes. The trustee can invest the money or distribute it to the trust beneficiaries as directed in the trust agreement.
An ILIT also allows the estate owner to determine when, and under what circumstance, the beneficiaries can receive the proceeds. The trust assets can be distributed gradually over time or in a lump sum. Some people restrict distributions of the trust assets for a period of time, which helps protect against irresponsible spending or bad investment decisions.
Removing Assets from the Estate
As Bob Carlson, editor of RetirementWatch.com, said, “The wealthy or near-wealthy who have enough assets to pay for retirement should consider removing appreciating assets from their estates.” A surefire way for a person to reduce the size of an estate is to spend the assets.
A person can also hand off portions of their wealth to family members through tax-free gifts. The annual gift tax exclusion allows a person to make tax-free gifts up to the exclusion amount each year. The exclusion amount is indexed for inflation but is $15,000 per recipient for 2021. Gifts that qualify for the exclusion amount also don’t reduce the giver’s lifetime estate and gift tax exemption.
A person can make gifts to as many people as he or she wants using the exclusion amount. There’s a separate $15,000 exclusion amount each year for each recipient. So, if you have three children, you can give each child $15,000 each year without worrying about gift or estate taxes. Married couples can give joint gifts of $30,000 per recipient each year.
Giving gifts can reduce the size of a person’s estate by millions of dollars and can help a person reduce the assets to below the exempt amount. Gifts also let you see how the gifts are used and how they benefit loved ones.
Making Charitable Donations
Under the estate and gift tax, there’s an unlimited deduction for charitable gifts. These amounts are deducted from the value of your estate before the estate tax is determined. So, making charitable gifts is one way to reduce or avoid estate taxes. The gifts can be made during your lifetime or through your estate.
One way to take advantage of this is through a charitable remainder trust. A charitable remainder trust (CRT) allows a person to convert appreciated investments into a source of lifetime income while avoiding capital gains tax and estate taxes. With a CRT, a person transfers to an irrevocable trust. That removes the assets from the estate and provides an immediate charitable contribution income tax deduction. You receive annual income payments from the trust for life or a period of years, whichever you designate. Upon one’s death, the assets remaining in the trust are donated to a charity you selected.
A CRT also can be set up in your will. Your estate transfers assets to the CRT. The CRT pays income to beneficiaries you designated (such as your children) for life or for a period of years. After the income period ends, the assets remaining in the trust go to charities you designated. The estate gets a charitable contribution for part of the value of the assets transferred to the CRT. That reduces the estate tax.
Family Limited Partnership
A family limited partnership (FLP) can reduce gift and estate taxes. There are many variations of this strategy, because it is very flexible. But in a standard FLP arrangement, you as the estate owner created a limited partnership with you as the general partner and initial limited partner. You transfer assets to the FLP. The assets can be a small business, real estate, investments, or others.
Then, you begin transferring the limited partnership interests to your children or other intended beneficiaries. When the FLP is structured properly, for gift tax purposes the value of the limited partnership interests you transfer to others is less than the pro rata value of the partnership property. That’s because the limited partnership interests aren’t readily marketable, and the limited partners have limited rights to influence partnership decisions. As a general partner, you still have most of the control over management of the partnership assets.
By transferring the limited partnership interests to family members, you’ve removed the value of those interests from your estate. And you’ve done it at a discount, because of the reduced value of the limited partnership interests.
Under the federal estate tax as of 2021, most people don’t have to worry about federal estate and gift taxes. For those few whose estate might face the estate taxes, there are strategies available to reduce or eliminate the tax. But the estate tax and strategies to reduce it are complicated. Be sure to work with an experienced estate planner before implementing a strategy to reduce estate taxes.
Important assistance for this summary of “How to Reduce or Avoid Estate Tax” goes to Bob Carlson, editor of the Retirement Watch financial advisory service and chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets.
Jaxon Kim is an editorial intern with Eagle Financial Publications.