If you die this year and have more than $5.49 million in assets, the federal government could tax the excess to the tune of 40 percent. Depending where you live, your state government might take a share too.
"Some people don't care about estate taxes," says Erin Durkin, director of financial planning for EP Wealth Advisors. "They think, I'm out of here. My kids can pay."
However, some financial experts say that might be the wrong attitude. Minimizing estate taxes is about ensuring the money you worked hard to earn and save will be used for purposes that are important to you. "At the end of the day, you're trying to maximize the estate, not minimize the amount the kids have to pay," says Ash Toumayants, owner of Strong Tower Associates in State College, Pennsylvania.
Here's how to protect your legacy and keep your cash out of government coffers.
Know whether your estate will be taxed. Estate taxes may seem like a problem for only the ultra-wealthy, but even middle class families can find themselves hit with a bill. Bank accounts, investments, property, businesses and life insurance are among the assets added to determine the size of an estate. Even those who don't hit $5.49 million may be on the hook for state estate taxes, which typically have a lower threshold. "The surprises come from real estate and businesses," Durkin says. A couple of pieces of rental or vacation property can quickly push the value of an estate skyward, particularly in states like California, where real estate is pricey.
If you own a business, its value will also be added to your estate. "Business owners are notoriously bad at valuing their businesses and net worth," Toumayants says. In some cases, heirs may find themselves blindsided by a significant tax bill because the value of the business is much more than the owner thought. Toumayants says farm families, in particular, may run into this problem because of the value of their land.
Start giving away your wealth now. One way to avoid or minimize estate taxes is to reduce the value of your estate. "An easy way [to do that] is to give annual gifts to your children, grandchildren or others," says Andy Schwartz, principal of Bleakley Financial Group in Fairfield, New Jersey. "Each individual is allowed to give away $14,000 annually to as many people as he or she chooses." Donating to charitable organizations is another way to give away money and reduce the size of an estate. Those donations may be tax deductible, too.
Use your exemption early for appreciating assets. The government grants each individual a $5.49 million lifetime exemption from estate taxes. While this exemption is usually claimed at the time of a person's death, Schwartz says it can be used at any time. In some cases, it may make sense to use the exemption to give away an asset now in order to avoid estate taxes later.
"Let's say I have a highly appreciating asset," Schwartz says. This could be anything that is expected to grow in value significantly in the coming years, although a business is the most likely candidate for this scenario. "I can use my lifetime exemption now to give it to the kids with the idea that my [current] $5.49 million asset will be worth $20 million [when I die]." By gifting the asset while it's at or below the lifetime exemption limit, heirs can avoid a costly tax bill later.
Put your assets in a trust. "The only real way to avoid taxes is to create trusts," Toumayants says. Some people balk at the idea because it hands control of their money over to someone else, but Toumayants notes this person can be a family member.
There are several types of trusts available, and a financial planner can help you determine how best to use a trust to shield assets from estate taxes. Durkin notes a qualified personal residence trust can exclude real estate from an estate, while Schwartz recommends a credit shelter trust for assets after one partner in a marriage dies. "The [surviving] spouse has complete access to that, but on her death, it's excluded from her estate," Schwartz says.
Buy extra life insurance to cover the cost. High-net-worth people who know they can't entirely avoid estate taxes may want to buy a life insurance policy to foot the bill after they're gone. "It doesn't go through probate, and it goes directly to beneficiaries," Toumayants says. The key is to set up an irrevocable life insurance trust to buy the policy. Otherwise, the value of the policy may be added to the estate and push the tax bill even higher.
Two things are said to be certain in life: death and taxes. If you use these strategies, you won't escape death, but you could say goodbye to some taxes.