Estate planning can be daunting, but it’s one of the most crucial steps you can take to ensure your legacy continues as you intend.
An often-overlooked aspect of estate planning is the impact of taxes on your heirs. Without proper planning, a significant portion of your assets could end up in the hands of the government instead of your loved ones’.
What is an Estate Tax?
When you pass away, the federal government may impose an estate tax on the value of your estate. The current federal estate tax exemption is relatively high at $13.61 million per individual or $27.22 million per married couple.
This exemption amount is currently scheduled to expire after 2025, at which point it will revert to around $7 million per individual, adjusted for inflation.
State estate taxes may also apply – depending on your residence at the time of your death – , which often have lower exemptions than at the federal level. Therefore, you’ll need to consider potential state estate taxes in your planning, as they can significantly reduce the amount your heirs inherit.
A qualified financial advisor can help you navigate the complex rules surrounding estate taxes. By understanding your financial situation and future goals, your advisor can craft a plan that minimizes the tax impact on your estate.
Strategies to Reduce Estate Taxes
Here are some key strategies your financial advisor might recommend to help reduce your estate tax burden:
- Gifting During Your Lifetime: You can reduce the size of your taxable estate by giving gifts during your lifetime. Under current tax laws, you can give up to a certain amount each year to as many individuals as you like without incurring gift taxes.The annual exclusion from gift tax is $18,000 per recipient for 2024. This is a straightforward way to transfer wealth to your heirs while potentially reducing your estate tax liability.
- Establishing Trusts: Trusts are powerful tools in estate planning. They allow you to control how your assets are distributed, while potentially reducing estate taxes. Different types of trusts serve different purposes, and your financial advisor can help you choose the one that best fits your needs. Following are some common types of trusts.
- Revocable Trust: Also known as a living trust, a revocable trust can be modified or dissolved by the person who created it. It allows assets to avoid probate and can provide for the management of assets in the event of incapacity.
- Irrevocable Trust: The terms of an irrevocable trust generally cannot be changed. Assets transferred into an irrevocable trust are typically removed from the grantor’s estate, potentially reducing estate taxes.
- Irrevocable life insurance trust (ILIT): An ILIT can help keep the proceeds of your life insurance policy out of your taxable estate, which can be particularly beneficial if you have a significant policy.
- Testamentary Trust: This trust is created through a will and becomes effective upon the death of the person who made the will. It can be used to manage assets for minor children or other beneficiaries.
- Charitable Trust: This type of trust benefits a particular charity or cause. There are different charitable trusts, including charitable remainder and lead trusts, each with tax and estate planning benefits.
- Asset Protection Trust: These trusts protect assets from creditors and legal judgments.
- Special Needs Trust: Intended to provide for the needs of a disabled beneficiary without disqualifying them from receiving government benefits.
Each type of trust has advantages and considerations, and your choice of which trust to use will depend on your specific circumstances and estate planning goals. Always consult with a financial or legal advisor to determine the best approach for your situation. - Charitable Giving: Charitable giving is another strategy to reduce estate taxes while supporting causes you care about. By including charitable donations in your estate plan, you can decrease the taxable value of your estate. Your financial advisor can help you structure these gifts to maximize the tax benefits and the impact on the charity.
A charitable remainder trust (CRT) allows you to donate assets to a charity while still receiving income from those assets during your lifetime. The remainder goes to the charity after your death, potentially reducing estate taxes while supporting a cause you’re passionate about.
Income Taxes and Your Estate
In addition to estate taxes, your heirs may also face income taxes on inherited assets. For example, when non-spouse beneficiaries inherit traditional IRAs or 401(k) accounts, they are generally required to pay income tax on their distributions. The tax liability can vary depending on the nature of the inherited asset and the beneficiary’s individual, tax situation.
Understanding how these taxes work is essential for creating an estate plan that minimizes the tax burden on your heirs.
- Roth Conversions: One strategy to mitigate the income tax burden on your heirs is to convert traditional retirement accounts to Roth IRAs. While you’ll pay taxes on the conversion, the Roth IRA distributions are generally tax-free, meaning your heirs won’t face income taxes on these assets.This strategy can be especially effective if you expect to be in a lower tax bracket now than your heirs will be in the future.Your financial advisor can help determine whether a Roth conversion makes sense for your situation. They can also assist in timing the conversion to minimize the tax impact.
- Strategic Withdrawal Planning: Another approach is strategically planning your retirement account withdrawals. By taking distributions during your lifetime, you can reduce the size of these accounts, potentially lowering the income tax burden on your heirs.
If you’re already in retirement, your financial advisor might suggest taking more significant withdrawals during years when your income is lower, thereby reducing the overall tax impact.
Other Considerations
Other considerations in estate planning can impact your heirs. For example, how assets are titled can affect how they’re transferred upon death. Joint property may pass directly to the surviving owner, potentially avoiding probate, but not necessarily estate taxes.
Final Thoughts
Estate planning is more than deciding who gets what; it’s about ensuring your legacy is preserved in the most tax-efficient way possible. By working with a financial advisor, you can develop a comprehensive estate plan that minimizes the tax burden on your heirs, allowing them to benefit fully from the assets you leave behind.
Taking proactive steps now can save your loved ones significant financial stress later. Whether through gifting, trusts, charitable giving, or strategic income tax planning, your financial advisor can guide you through the options and help you create a plan that aligns with your goals and values.
Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.