CHAPTER 3
The Estate Tax System
Determining Your Estate Net Worth
Although minimizing the amount of estate taxes you will owe should not be your only goal, it is certainly an important one. The estate tax system places a tax on the transfer of wealth for the purpose of redistributing it to the masses. The transfer tax system comprises less than 2 percent of the revenue raised through taxation in the United States. Under prior tax law, many middle-income Americans began to discover that they, too, faced the possibility of estate taxes. The 2012 Tax Relief Act refocused on wealthy Americans but even though the exclusion amounts are at an all-time high, the estate tax can affect the unwary because of the wide reach of the tax. For instance, most people are surprised to learn that life insurance proceeds are subject to the tax when the policy is owned by the insured. Table 3.1 is a reminder of the current estate and gift tax limits.
TABLE 3.1 Applicable Federal Gift and Estate Tax Exemption Amounts
| Year of Death | Gift Tax Exemption ($) | Estate Tax Exemption ($) |
| 2014a | 5,340,000 | 5,340,000 |
a For subsequent years, the gift and estate tax exemptions are indexed for inflation. For current year updates, visit the Resource Center at www.welchgroup.com; click on “Links,” then “Estate Book Updates.”
Understanding the Estate Tax System
It seems like everything you do subjects you to another tax: Your earnings are subject to income taxes; your purchases are subject to sales tax; your real estate holdings are subject to property tax; your security sales are subject to capital gains taxes. It's hard to believe that you or your heirs are expected to pay taxes upon your death. The government does give you a break, but to receive the maximum benefits you must plan carefully. Here's how the system works:
First, you die. Ouch! Then your executor makes a list of all of your assets (called an estate inventory) to determine your gross estate.
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Executor: The person or institution that is legally responsible for settling an estate. He or she may also be referred to as the estate representative or administrator. Normally you appoint an executor by way of instructions in your will.
The executor then subtracts from the gross estate all allowable exemptions and deductions, which include your liabilities, notes, and mortgages (assuming the estate is liable for the debt), funeral expenses, and administrative costs of settling your estate (attorneys' fees, court costs, etc.). If you were married, any assets left to your spouse would not be subject to estate taxes at this time because of the unlimited marital deduction, so the value of the assets left to your spouse are also deducted (the government waits until your spouse dies and then assesses the estate tax). If you leave money to qualified charities, you get to deduct that as well. You have now arrived at your taxable estate. If you made taxable gifts during your life, then adjusted taxable gifts are added to the taxable estate to determine your tax base.
- Unlimited marital deduction: The legal provision that enables you to leave an unlimited amount of assets to a surviving spouse free of estate taxes. This has the effect of postponing the estate taxes until the death of that spouse.
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Adjusted taxable gifts: The total amount of taxable gifts you made during your life less any gifts that are included in your gross estate because of the “string provisions” of Internal Revenue Code (IRC) §§ 2035–2039, which are discussed later in the book.
Your executor then figures the tentative tax using the IRS tax tables (see Table 3.2). Note: The rate is essentially now a flat tax rate because in order for estate tax to be imposed, the taxable estate must always be in excess of the amount at which the highest rate applies.
From the tentative tax amount your executor subtracts the applicable federal gift and estate tax credit. This is a dollar-for-dollar deduction from the tentative tax amount (see Table 3.3).
- Applicable federal gift and estate tax credit. The dollar credit amount allowed by the federal government that has the effect of making a certain portion of your estate not subject to taxes.
TABLE 3.2 Federal Gift and Estate Tax Rate Table (Tentative Tax)
| On Amount in | |||
| Taxable Estate ($) | Tax Owed ($) | Plus (%) | Excess of ($) |
| 0–10,000 | 0 | 18 | 0 |
| 10,001–20,000 | 1,800 | 20 | 10,000 |
| 20,001–40,000 | 3,800 | 22 | 20,000 |
| 40,001–60,000 | 8,200 | 24 | 40,000 |
| 60,001–80,000 | 13,000 | 26 | 60,000 |
| 80,001–100,000 | 18,200 | 28 | 80,000 |
| 100,001–150,000 | 23,800 | 30 | 100,000 |
| 150,001–250,000 | 38,800 | 32 | 150,000 |
| 250,001–500,000 | 70,800 | 34 | 250,000 |
| 500,001–750,000 | 155,800 | 37 | 500,000 |
| 750,001–1,000,000 | 248,300 | 39 | 750,000 |
| 1,000,000 | 345,800 | 40 | 1,000,000 |
TABLE 3.3 Applicable Federal Gift and Estate Tax Credit and Exclusion Amounts
| Year of Death | Applicable Credit Amount ($) | Basic Exclusion Amount ($) |
| 2014 | 2,081,800a | 5,340,000a |
a Indexed annually for inflation.
If the result of subtracting the applicable gift and estate tax credit is a positive number, that is the amount of taxes that are due. Your executor must then raise the cash to pay the taxes. Generally, the tax is due nine months from the date of your death. Once the taxes are paid, your executor distributes the balance of your assets according to the directions given in your will. If you do not have a will, your assets will be distributed according to state law (see Chapter 6). This process can take from six months to several years. Sound confusing? Let's walk through an example.
Case Study
Alfred and Jane Crocker want to develop a plan that will minimize taxes and set up trusts for their two daughters in case they die prematurely. Our first objective is to determine their current estate tax liability. We do this by completing Worksheet 3.1.
Next, we need to determine the Crocker's potential estate tax liability. Let's assume that Alfred dies first. Alfred has named Jane as the beneficiary of all of his life insurance policies and his retirement plans. Most of their other assets, such as their home and personal property, are titled in both of their names ( joint tenants with right of survivorship). So all of Alfred's assets would be transferred to Jane (see Worksheet 3.2).
WORKSHEET 3.1 Sample Estate Net Worth Statement
| As of 2/20/XX
Your name: Alfred Crocker Date of birth: 6/29/XX Spouse name: Jane Crocker Date of birth: 5/20/XX |
||||
| Ownership ($) | ||||
| Alfred | Jane | Joint | Family
Total |
|
| Assets | ||||
| Cash and cash equivalents: | ||||
| Checking and savings accounts | 27,000 | 27,000 | ||
| Other | 250,000 | 163,000 | 413,000 | |
| Personal and household property: | ||||
| Automobiles | 46,000 | 32,000 | 78,000 | |
| Furniture | 95,000 | 95,000 | ||
| Jewelry | 5,000 | 45,000 | 50,000 | |
| Personal effects | 23,000 | 19,000 | 42,000 | |
| Art | 115,000 | 115,000 | ||
| Coin collections | ||||
| Other | ||||
| Real estate (estimated current
market value): |
||||
| Residence(s) | 2,950,000 | 2,950,000 | ||
| Other properties | 650,000 | |||
| Investments (estimated current
market value): |
||||
| Individual stocks | ||||
| Individual bonds | ||||
| Personal mutual funds | 250,000 | 250,000 | ||
| Other investments: Ltd. partnership | 25,000 | 25,000 | ||
| Retirement plans: | ||||
| Alfred's 401(k) and IRA | 1,625,000 | XX | 1,625,000 | |
| Jane's IRA | 25,000 | XX | 25,000 | |
| Equity interest in a business | XX | |||
| Life insurance (face amount): | ||||
| Personal | 4,750,000 | 250,000 | XX | 5,000,000 |
| Employer group | 125,000 | XX | 125,000 | |
| Total assets | 7,249,000 | 621,000 | 3,600,000 | 11,470,000 |
| Liabilities | ||||
| Short-term liabilities: | ||||
| Credit cards | 21,500 | 9,750 | 31,250 | |
| Long-term liabilities: | ||||
| Mortgage(s) | 490,000 | 490,000 | ||
| Automobile loan(s) | 14,000 | 7,000 | 21,000 | |
| Other loans: Home equity loan | 57,000 | 57,000 | ||
| Miscellaneous liabilities: | ||||
| Unpaid taxes | ||||
| Estimated funeral and administrative | ||||
| expensesa | ||||
| Total liabilities | 35,500 | 16,750 | 547,000 | 599,250 |
| Taxable estate (total assets | ||||
| less total liabilities) | 7,213,500 | 604,250 | 3,053,000 | 10,870,750 |
a Funeral and administrative expenses can vary from 2 percent to 8 percent. For the sake of simplicity, they are ignored in this case study.
WORKSHEET 3.2 Jane's Estate Net Worth Statement after Alfred's Death
| As of 2/20/XX
Your name: Jane Crocker Date of birth: 5/20/XX |
|
| Ownership ($) | |
| Jane | |
| Assets | |
| Cash and cash equivalents: | |
| Checking and savings accounts | 27,000 |
| Other | 413,000 |
| Other: Proceeds from life insurance | 4,875,000 |
| Personal and household property: | |
| Automobiles | 78,000 |
| Furniture | 95,000 |
| Jewelry | 50,000 |
| Personal effects | 42,000 |
| Art | 115,000 |
| Coin collections | |
| Other | |
| Real estate (estimated current market value): | |
| Residence(s) | 2,950,000 |
| Other properties | 650,000 |
| Investments (estimated current market value): | |
| Individual stocks | |
| Individual bonds | |
| Personal mutual funds | 250,000 |
| Other investments: Ltd. partnership | 25,000 |
| Retirement plans: 401(k) and IRAs | 1,650,000 |
| Equity interest in a business | |
| Life insurance (face amount): | |
| Personal | 250,000 |
| Total assets | 11,470,000 |
| Liabilities | |
| Short-term liabilities: | |
| Credit cards | 31,250 |
| Long-term liabilities: | |
| Mortgage(s) | 490,000 |
| Automobile loan(s) | 21,000 |
| Other loans: Home equity loan | 57,000 |
| Miscellaneous liabilities: | |
| Unpaid taxes | |
| Estimated funeral and administrative expensesa | |
| Total liabilities | 599,250 |
| Taxable estate (total assets less total liabilities) | 10,870,750 |
a Funeral and administrative expenses can vary from 2 percent to 8 percent. For the sake of simplicity, they are ignored in this case study.
Because of the unlimited marital deduction, there are no estate taxes due at Alfred's death. Our attention is drawn to the possible estate tax should Jane now die prematurely or if the combined estate of Jane and Alfred will likely grow to the point that it will become large enough to be subject to estate taxes in the future. And if this is the case, what can we do to minimize this risk while both Alfred and Jane are able to make changes to their estate plan?
| Step 1 | Determine the total value of Jane's assets (including her life insurance). This represents her gross estate. | $11,470,000 |
| Step 2 | Determine Jane's liabilities that her estate would be liable for. | –$599,250 |
| Step 3 | Subtract the following: | |
| (a) Charitable contributions made through Jane's will | –$0 | |
| (b) Unlimited marital deduction (not applicable for Jane | –$0 | |
| (c) Liabilities for which Jane's estate is liable | –$599,250 | |
| (d) Estimated funeral and administrative costs | –$30,000 | |
| Step 4 | This figure represents the taxable estate. | $10,840,750 |
| Step 5 | Compute the gross federal estate tax using Table 3.2. | $4,282,100 |
| Step 6 | Subtract the applicable credit amount (for Jane) (Table 3.3). | –$2,081,800 |
| Step 7 | Subtract applicable credit amount (for Alfred because of portability). | –$2,081,800 |
| Step 8 | This is the amount of tax due on Jane's estate. | $118,500 |
First, we should note (see Step 7) that under the 2012 Tax Relief Act, the surviving spouse “inherits” any unused exclusion amount from the deceased spouse, which allows the heirs to apply two applicable credit amounts toward any estate taxes. While the estate tax in our case study is not large, it could have been eliminated. What is significant is that we have identified a potentially costly problem in the form of rising estate costs as the value of the Crocker's estate continues to grow with all future growth subject to a 40 percent estate tax rate. There are many strategies we can use to substantially reduce or eliminate the Crocker's tax liability.
Your Estate Tax Picture
Now, let's determine the value of your estate and your potential taxes. Don't forget to include the death benefit of any life insurance on your or your spouse's life that is owned by you and your spouse.
Step 1
Add up the value of all your assets using Worksheet 3.3. Note that the dollar figure we are looking for is the market value, not what you paid for the asset.
Market value: The value of an asset if it were sold today, net of all selling expenses.
Let's start with the obvious: You own everything solely in your name. You must also include any assets of which you are a joint owner. For example, if you own a hunting lodge with your brother, your one-half interest would be included in your estate. The same is true, for example, if you own your home jointly with your spouse. Some care must be taken in allocating ownership of jointly held property. For example, in the case where you own the hunting lodge with your brother, if you paid for 90 percent of the purchase price, then 90 percent of the value would be included in your estate unless you made a gift to your brother. Also, do not overlook any life insurance you own. If the insurance is on your life, remember, it is the death benefit that will be included in your estate, not the cash value. If someone owes you money, the value of that note or accounts receivable should be included as an asset of your estate. Also, do not forget items of personal property like cars, boats, clothing, jewelry, and so on.
- Death benefit: The proceeds your beneficiary would receive from the life insurance company upon your death.
WORKSHEET 3.3 Your Estate Net Worth Statement
| As of
Your name: Date of birth: Spouse name: Date of birth: |
||||
| Ownership ($) | ||||
| You | Spouse | Joint | Family
Total |
|
| Assets | ||||
| Cash and cash equivalents: | ||||
| Checking and savings account | ||||
| Other | ||||
| Personal and household property: | ||||
| Automobiles | ||||
| Furniture | ||||
| Jewelry | ||||
| Personal effects | ||||
| Art | ||||
| Coin collections | ||||
| Other | ||||
| Real estate (estimated current market value): | ||||
| Residence(s) | ||||
| Other properties: | ||||
| Investments (estimated current market value): | ||||
| Individual stocks | ||||
| Individual bonds | ||||
| Personal mutual funds | ||||
| Other investments: | ||||
| Retirement plans: | XX | |||
| XX | ||||
| XX | ||||
| Equity interest in a business | XX | |||
| Life insurance (face amount): | ||||
| Personal | XX | |||
| Employer group | XX | |||
| Total assets | ||||
| Liabilities | ||||
| Short-term liabilities: | ||||
| Credit cards | ||||
| Long-term liabilities: | ||||
| Mortgage(s) | ||||
| Automobile loan(s) | ||||
| Other loans | ||||
| Miscellaneous liabilities: | ||||
| Unpaid taxes | ||||
| Estimated funeral and administrative expensesa | ||||
| Total liabilities | ||||
| Estate net worth (total assets less total liabilities) | ||||
a Funeral and administrative expenses can vary from 2 percent to 8 percent.
Step 2
Still using Worksheet 3.3, add up all the money you owe, including debts, mortgages, and liens. If you owe money on jointly owned property, only your share of that debt counts. You also should include any unpaid property or income taxes, as well as the cost of funeral and administrative expenses. Funeral expenses can vary from $2,000 to $20,000 or more. Although administrative expenses can vary widely, a generous rule of thumb would be 5 percent of your gross estate.
Step 3
Using Worksheet 3.3, determine if the liabilities are of a nature that your estate will be responsible for the liability. In this case, Jane's estate would be responsible for the liabilities. Thus, the entire value of the assets, not reduced by any liability is included in your gross estate. If your estate is not responsible for the liability, say in the case of a nonrecourse loan, then only the equity value of the asset is included in your gross estate. Note, however, that in the example of a nonrecourse loan, your estate does not get a deduction for the debt. In other words, your estate may only deduct debts that it is legally responsible to pay.
Step 4
As mentioned earlier, you may deduct the amount of debts that your estate is liable for. In addition, you may deduct funeral expenses, administrative expenses, and claims against the estate. Additionally, the government allows you two primary unlimited deductions:
- The unlimited marital deduction. If you are married, you can leave an unlimited amount of assets to your spouse free of any estate taxes! At first blush, this appears to be the perfect solution to your estate tax dilemma. But when planning your estate you must look beyond this rule for ways to reduce the amount of taxes that your heirs will ultimately pay.
- Charitable contributions. If you leave money or assets to qualified charitable organizations in your will, you will receive a deduction for estate tax purposes.
| Gross estate (from Worksheet 3.3) | $ |
| Minus funeral expenses, administrative expenses, claims against | |
| the estate and unpaid mortgages | – |
| Minus marital deduction (either a “0” if there is no surviving | |
| spouse or 100 percent of assets left to your surviving spouse) | – |
| Minus charitable bequests in your will | – |
| Your taxable estate | $ |
Step 5
By taking the deductions from Step 4, you have arrived at your taxable estate. If you are married and using the marital deduction, you will have effectively postponed your estate taxes until your surviving spouse dies. To better understand the impact of estate taxes, let's assume you and your spouse die simultaneously or that you are not married.
Step 6
Calculate your gross federal estate tax. Apply the tax rates from Table 3.2 to determine the gross federal estate tax. This represents your tentative tax.
In our case study, calculate the gross federal estate tax by first determining the taxable estate, which in the preceding example for Jane is $10,840,750 (gross estate of $11,470,000 less deductions). Using Table 3.2, the tax on $10,840,750 is $345,800 plus 40 percent of the excess over $1 million. Thus, the tentative tax is $345,800 plus ($9,840,750 × 40 percent) or $4,282,100.
Step 7
From the tentative tax, you now get to subtract the applicable credit amount. This credit allows you to give a certain amount of your estate to anyone without owing federal estate taxes (called the applicable exclusion amount). See Table 3.3 for details. Note that this credit is applied directly dollar-for-dollar against the tentative tax as calculated in Step 6. You may be able to use two credits under the portability provisions of the 2012 Tax Relief Act—one for you and for your deceased spouse if he or she has not already used his or her credit.
In our example, Jane's credit of $2,081,800 is subtracted from $4,282,100. Additionally, because Alfred did not use any of his credit by leaving everything outright to Jane, Jane may use Alfred's unused exclusion amount, which is equal to a credit of $2,081,800. Therefore, the total amount of tax owed by Jane's estate is $118,500.
Your Future Estate
If your result in Step 7 is a positive number, that is the tax you would owe, and it is time for you to meet with your professional adviser(s) to develop a plan for tax minimization. If your answer is a negative number, then you currently would not owe any estate taxes.
In addition to federal estate taxes, many states impose their own death or inheritance taxes.
Even if it appears now that no taxes will be owed on your estate that may not be the case later as you accumulate more assets and the assets you have increase in value over time. Table 3.4 shows future estate values based on various growth rates. Keep these figures in mind as you begin planning. Some of the growth rates in Table 3.4 may seem unrealistic, but if you are still working, in addition to growth of existing assets, you are hopefully accumulating new assets through contributions to retirement plans, personal investment programs, and acquisitions. In fact, these growth rates may be too conservative. It's a good idea to update your estate net worth worksheet annually so you can gain a sense of your estate's growth rate. This will indicate the kind of planning you will need to consider in the future. In reviewing your estate situation, it is also important to consider any potential inheritances that you are likely to receive.
TABLE 3.4 The Future Value of Your Estate
| Current Estate Value ($) | 10 Years ($) | 15 Years ($) | 20 Years ($) |
| 3% Growth Rate | |||
| 500,000 | 672,000 | 778,000 | 903,000 |
| 750,000 | 1,008,000 | 1,168,000 | 1,354,000 |
| 1,000,000 | 1,344,000 | 1,558,000 | 1,806,000 |
| 2,000,000 | 2,688,000 | 3,116,000 | 3,612,000 |
| 3,000,000 | 4,032,000 | 4,674,000 | 5,418,000 |
| 5% Growth Rate | |||
| 500,000 | 814,000 | 1,039,000 | 1,326,000 |
| 750,000 | 1,221,000 | 1,559,000 | 1,984,000 |
| 1,000,000 | 1,628,000 | 2,078,000 | 2,653,000 |
| 2,000,000 | 3,257,000 | 4,157,000 | 5,306,000 |
| 3,000,000 | 4,886,000 | 6,236,000 | 7,959,000 |
| 7% Growth Rate | |||
| 500,000 | 983,000 | 1,379,000 | 1,934,000 |
| 750,000 | 1,475,000 | 2,069,000 | 2,902,000 |
| 1,000,000 | 1,967,000 | 2,759,000 | 3,869,000 |
| 2,000,000 | 3,934,000 | 5,518,000 | 7,739,000 |
| 3,000,000 | 5,901,000 | 8,277,000 | 11,609,000 |
| 9% Growth Rate | |||
| 500,000 | 1,183,000 | 1,821,000 | 2,802,000 |
| 750,000 | 1,775,000 | 2,731,000 | 4,203,000 |
| 1,000,000 | 2,367,000 | 3,642,000 | 5,604,000 |
| 2,000,000 | 4,734,000 | 7,284,000 | 11,208,000 |
| 3,000,000 | 7,102,000 | 10,927,000 | 16,813,000 |
Overview of Estate-Planning Strategies
There are many techniques and strategies that can help you achieve your estate-planning goals. Some of the more powerful ones include the following:
- Wills. A will forms the cornerstone of most people's estate plan. Wills can provide tremendous flexibility for controlling assets and avoiding taxes. Chapter 7 provides details for drafting your will.
- Trusts. You can use trusts during your lifetime or after your death to help implement your estate game plan. Various types of trust planning will be discussed throughout Chapter 8.
- Retirement accounts. Retirement plans are key to wealth accumulation. In Chapter 4 we will show you ways to increase their effectiveness tenfold.
- Gifting. One way to reduce your estate (and thereby your taxes) is to give part of your estate away. In Chapter 11 you will learn how to create leverage with a gifting program, as well as how to maintain a measure of control over gifted assets.
- Charities. There are several strategies, such as the charitable remainder trust, whereby you can improve your financial circumstances while helping your favorite charity. In Chapter 12 you will learn how you can benefit from charitable donations.
- Family limited partnerships. Using a family limited partnership can shift assets to family members at a significant discount from their current value. Family limited partnerships are reviewed in Chapter 13.
In this chapter, you have learned about our estate tax system and about your specific situation. Since money is the glue that holds an estate plan together, the next chapter will focus on investment strategies you can use to maximize your estate accumulation plan.