While estate taxes impact only a small part of the U.S. population, several legal loopholes are available that can mitigate the potential financial impact of estate taxes. on those who inherit such estates. Taking advantage of these opportunities involves proper foresight, effective communication, reliance on trusted advisors, and consistent planning over time. The purpose of this Navigator is to outline some of the key components of prudent estate planning and discuss some of the ways that estate owners can reduce the burdens that would otherwise fall on their heirs.
By definition, estate planning is the process by which individuals specify how their money and other property should be managed and distributed during life and post-death. In the past, we wrote an introduction to estate planning; separately, we published a Navigator about the critical task of selecting a trustee, which is an important component of the estate planning process.
All too often, estate planning is a neglected aspect of long-term financial planning, given the required forward-looking mentality, substantial effort, and considerable expense involved in the process. For many, it is easier to kick the can down the road and do nothing, rather than try to answer tough questions such as “What happens to my assets and my minor children when I die? Should I even try to limit the tax implications of my death?” As a result, only one-third of Americans have created a will of any kind, and a much smaller proportion of people have committed the necessary time and resources to construct a prudent estate plan.1
For those forward-looking people who want to maximize the value of the assets that are transferred to the next generation, a combination of strategies can be properly employed to achieve that goal. These tools involve the assistance of trusted advisors like attorneys, accountants, and financial advisors, while proper, direct communication with heirs also plays an important role in this process.
Consider Your Estate in Context of Existing
Estate and Gift Tax Laws
One of the primary reasons to create an estate plan is to minimize estate-related taxes. These taxes can be punitive if the size of your estate is significant, and it is important to understand how they work in order to maximize the after-death value of your estate to your heirs.
Gift taxes can apply to certain transfers of assets or interests in property that you make to another while you are still alive. As of 2023, you can gift up to $17,000 in assets per person annually without those gifts counting against your individual lifetime gift exemption. While gift taxes apply while you are alive, estate taxes are associated with distributing your property after death. As of 2023, you can leave up to $12.92 million (the current individual lifetime gift exemption) to your heirs and not pay any Federal estate taxes. Similarly, a married couple will be able to shield up to $25.84 million ($12.92 million times two people) from Federal estate taxes.2 Given the large size of the Federal exemption level, over 99% of U.S. taxpayers do not have to worry about the Federal estate tax diminishing what they plan to leave to their loved ones. However, any assets distributed to heirs above the $12.92 million minimum would be taxed on the Federal level at a rate of up to 40%.3
Put Your Estate in Order
Even if your estate falls below the exemption level, it still will behoove you and your heirs to put your estate in order well before you meet your maker. Below are some basic guidelines that we believe will create a well-constructed estate plan:
Use qualified professional assistance in your estate planning
Trusted advisors (e.g., estate lawyers, accountants, and financial advisors) have vast knowledge and understanding of how inheritance challenges can and will affect you and your estate. They can provide strategic direction for your own plans, which will improve the chances of success in your estate endeavors. For complicated estates, using a set of trusted advisors to guide you in the process is a necessity.
Inventory your assets and work with your advisor to model your estate
Prior to starting a proper estate plan, you will want to generate a comprehensive list of your assets and liabilities. Your financial advisor and your estate lawyer will need this information in order to properly guide you through your planning activities. This Roadmap for Heirs not only helps you to list out your personal balance sheet, but it also helps estate executors and heirs to work through some of the administrative details that accompany your eventual demise. At a basic level, it can act as a central repository of estate documents, important contacts, and helpful directions that can streamline the process of gathering important information regarding your personal affairs and your commitments to your beneficiaries.
With this personal balance sheet, your financial advisor can help to model out the growth of your assets over time. This information can provide you with valuable insight on key decisions that may benefit your heirs (e.g., the extent to which you gift assets to your heirs on an annual basis to keep your assets below the Federal and/or relevant state exemption levels).
Address your family needs
Once you have established the size of your taxable estate and done some forecasting on asset growth over time, then you need to consider how best to protect the assets and your family after you have passed. Working with an estate lawyer, you need to establish a will and/or trusts to direct how the assets are treated post-death. If your children are reasonably young, then you need to consider whether you have enough life insurance to accommodate their future needs, should you meet an early demise. In addition, you will need to think about naming a potential guardian for your minor children should you die while your children are young.
While your will and other trusts may explicitly state the wishes for your assets, these documents may not necessarily be all-inclusive. More specifically, retirement portfolios and insurance products typically have beneficiary designations that need to be updated regularly, and these beneficiary designations
Establish your specific directives
A comprehensive estate plan includes several important legal directives. In many cases, it is prudent to establish a trust. You place your assets into this trust and select a trustee (which could be you while you are alive) to manage the assets for your benefit and that of any beneficiaries. Should you become ill, incapacitated, or dead, the legal directives in the trust provide for the proper management and/or transfer of the assets in the trust.
Ways to Limit Estate Taxes
Putting your estate in order is merely the first step necessary for a well-constructed estate plan, and those actions by themselves have little direct impact on estate taxes. For those who have estates that may trigger Federal and/or state estate taxes, there are a number of mechanisms available to mitigate that financial impact, once the estate is in order.
- Make regular gifts to your heirs
As previously mentioned, you can give up to $17,000/person in annual gifts without using up any of your lifetime estate tax exemption. While this strategy seems on the surface to only have a minor impact on limiting the estate bill for your heirs, giving these assets to many heirs over a long period of time can make a material difference.
- Convert your traditional IRA to a Roth IRA
With an inherited IRA, most heirs are forced to take distributions over a 10-year period, and these distributions have taxable implications for those heirs at ordinary income tax rates. As a result, it may make sense for you to convert your traditional IRA to a Roth IRA prior to your death. In that case, you pay the tax bill on the Roth IRA conversion prior to your death; post-death, your heirs pay zero income taxes on the required distributions, as the Roth IRA is distributed to them over the subsequent 10 years with no tax implications.
- Putting assets out of your estate
Certain irrevocable trusts can be used to remove assets from your estate. For example, you can create an irrevocable life insurance trust to eliminate life insurance proceeds from your estate. The proceeds of any life insurance policies owned by such a trust would not be subject to the estate tax upon death.
- Make charitable donations
Upon your death, you can specify that your estate will make a charitable donation that limits the amount of taxes that your estate would have to pay. Of course, that means that your heirs receive less capital from your estate. You can do this directly upon your death or set up a charitable remainder trust in which a grantor initially transfers assets to their beneficiary and then subsequently disperses the remainder of the assets to charity. This trust also enables the grantor to take a partial income tax deduction for funding the trust during his or her lifetime.
- Establish a family limited partnership
Assuming that there is a family-owned business or other assets that you may want your children to continue to own after you have passed, a family-limited partnership may make sense. By establishing this partnership, you can continue to control the assets, but your heirs will have a stake in the assets. As a result, the size of your taxable estate will be smaller.
- Create a qualified personal residence trust
Similar to a family-limited partnership, you can transfer the ownership of your home into a qualified personal residence trust. You can continue to live in the home without paying rent during the term of the trust. After the term ends, your beneficiaries can take over the property. Through this mechanism, you can freeze the residence’s market value and reduce the size of your estate. However, should you pass before the end of the term of the trust, your home will still be part of the taxable estate.
- Directly pay for tuition for those who need it
Separate from gifting, you can pay for tuition expenses for your heirs. The tuition exclusion will allow you to pay for your heirs’ education costs and limit future estate taxes by making your estate slightly smaller by the amount of the tuition payments. This exclusion does not impact any annual or lifetime gifts that you may make to your heirs.
- Consider changing your state of residence
Currently, only 11 states and the District of Columbia levy a state estate tax, which is incremental to any Federal estate tax levied on your estate.4 Should you live in one of those states, then you may want to engage your advisors to understand the financial implications of continuing that state residence. Should the consequences of maintaining that state residence be excessive, then you may want to consider moving to a state that does not impose inheritance taxes.
Prepare the Next Generation
An important item that is too often neglected is the estate owner’s role in preparing the next generation for the impact of inheritance. Many people are unable to get over the taboo of discussing their assets with their heirs and therefore fail to address this important topic during life. In this case, not only is the next generation ill prepared for this wealth transfer, but also your goals for your assets may not necessarily be well communicated to them.
Moreover, significant responsibilities are delegated to your heirs when they are destined to inherit significant assets. Thus, providing them with adequate financial training makes sense, and your trusted advisors play a crucial role in helping them to get accustomed to having material wealth. Being smart with money is not an innate skill – proper orientation and training are required to engender prudence with inherited assets.
Very few people actually need to be concerned with the implications of having to pay estate taxes. However, if your estate is one of those where estate taxes will have a material impact, you can help to mitigate that tax burden if you plan ahead and make the most of the tax loopholes that may benefit the heirs of your estate.
Should you wish to discuss this issue further and how it may impact your estate more specifically, please reach out to your portfolio manager.
This article is prepared by Pekin Hardy Strauss, Inc. (“Pekin Hardy”, dba Pekin Hardy Strauss Wealth Management) for informational purposes only and is not intended as an offer or solicitation for business. The information and data in this article does not constitute legal, tax, accounting, investment or other professional advice. The views expressed are those of the author(s) as of the date of publication of this report, and are subject to change at any time due to changes in market or economic conditions. Pekin Hardy cannot assure that the strategies discussed herein will outperform any other strategy in the future, there are no assurances that any predicted results will actually occur.