Death and taxes may indeed be inevitable, but paying a so-called “death tax” is not. The way certain politicians rant, one might reasonably (but falsely) believe that upon a person’s death half of their estate will go to the federal government. The reality is that very few people are affected by the federal estate tax (aka “death tax”). For example (very generally speaking), in the case of a married couple, upon the death of one spouse the entire estate passes tax-free to the surviving spouse. Upon the death of the second spouse, a federal estate tax of up to 39% is applied to all assets above $5.25 million (as of 2013) not otherwise shielded from the tax before the remaining assets pass to the beneficiaries. If you (like most of us) leave behind an estate of less than $5.25 million ($10.5 million for a married couple), the federal estate tax doesn't apply at all.
However, the picture is quite different when it comes to estate taxes collected by state governments. For example, New Jersey’s estate tax applies to estates worth more than $675,000. In New York, the tax applies to estates worth more than $1 million. Upon first glance these numbers might also seem high, but it is important to note that virtually all assets in an estate are counted to arrive at its value (known as the “gross” estate). For example, all real estate is counted. Life insurance policies are counted. Retirement accounts are counted. Even most gifts made within 3 years of death are usually counted.
In the New York tri-state area, it is not uncommon for a home to be worth well upwards of $500,000. Add to that a pair of life insurance policies and a retirement account and one can see how easy it is to exceed the New Jersey and New York exemption amounts.
It is also important to note that unmarried couples —do not enjoy a tax-free transfer upon the death of one of the partners. So, if you not a legally married couple it is especially important to have an estate planning attorney that understands the issues and can develop an estate plan for you that mirrors as closely as possible the many rights and benefits afforded to married couples.
Regardless of relationship status, however, an estate tax can apply upon the death of the surviving spouse or domestic partner if the value of the estate exceeds the exemption amount (currently $675,000 in New Jersey and $1 million in New York). Therefore, it is important to have an estate planning attorney review your personal and financial circumstances in order to develop an estate plan that can either eliminate your estate tax exposure or at least reduce it significantly.
So, what can an estate planning attorney do to help you avoid or reduce these taxes? The good news is that there are many tools in the estate planning arsenal, including irrevocable life insurance trusts, bypass trusts, and the annual gift exclusion, to name a few.
Irrevocable Life Insurance Trusts
Often, a life insurance policy is the asset that makes an estate subject to estate taxes in the first place. It is not at all uncommon to have a life insurance policy providing a death benefit of several hundred thousand dollars or more—all of which is included in determining your gross estate. An irrevocable life insurance trust (ILIT) is a type of trust that is specifically designed to hold and own life insurance policies so as to remove them from the calculation of an estate’s value. Once a life insurance policy is irrevocably purchased by the trustee of the ILIT (usually a non-spouse trusted family member, accountant, or financial institution) to cover the life of the grantor of the ILIT (you), with the ILIT being the beneficiary of the policy upon your death, you will be deemed to have no ownership or control over the policy. Since you'll no longer own the policy or control its terms, the proceeds can't be taxed in your estate when you die.
Even if you already have a life insurance policy, ownership can be transferred to an ILIT. However, it is important to note that if you die within three years of the date when the policy was transferred to the ILIT, the life insurance proceeds will be included in your estate for tax purposes. This does not mean that the beneficiary will not receive the money, it merely means that your estate will have to count the proceeds as being part of your gross estate when computing the estate tax.
Since the ILIT is named as the beneficiary of the life insurance policy, after you die the insurance proceeds will be transferred into the ILIT and held in trust for the benefit of your spouse or partner during his or her remaining lifetime, with the balance passing to your children or other beneficiaries. Another benefit of the ILIT is that since the insurance proceeds will be held in trust for the benefit of your spouse or partner instead of being paid to that person outright, the proceeds can't be taxed in their estate, either.
An ILIT can be a very powerful and effective element of a well-designed estate plan, and can provide a great deal of benefit to your beneficiaries. However, this is a highly sophisticated estate planning technique, and there are certain administrative requirements to be followed, and important documents to be maintained. An estate planning attorney will not only be able to help you set up the ILIT, but also help ensure that all requirements and formalities are complied with.
A bypass trust can be helpful to a married couple by taking, upon the death of the first spouse, the applicable exemption amount ($675,000 in New Jersey, and $1 million in New York) and putting it into a trust for the benefit of the surviving spouse during his or her lifetime with the remainder going to the couple’s children—as opposed to leaving that amount to the surviving spouse outright. By using a bypass trust, the first spouse to die directs (i.e., via his or her will) that some of his or her wealth (up to the full exemption amount) be placed into a bypass trust upon their death. At death, that amount is transferred into the bypass trust, with the rest of the deceased spouse’s estate typically going to the surviving spouse outright. When the surviving spouse dies, the children receive the bypass trust assets (as successor beneficiaries to the trust) and the surviving spouse's assets (as beneficiaries under the surviving spouse’s will). Since assets in the bypass trust did not belong to the surviving spouse (they were, instead, held in trust for his or her benefit), they are not included in his or her estate when calculating the value of the estate for estate tax purposes. This may save a substantial amount of estate taxes.
Husband and Wife (Henry and Wilma) live in New York. Henry dies with an estate worth $2.5 million. In his will he provides for a bypass trust to be created in the amount of New York’s estate tax exemption amount ($1 million). The beneficiary of the bypass trust is Wilma, and during her lifetime she receives the income from the trust plus as much of the principal that, in the trustee’s discretion, is needed to keep her living in the manner to which she was accustomed. The rest of Henry’s estate ($1.5 million) passes outright and tax-free to Wilma. Upon Wilma’s death, whatever remains in the bypass trust will pass to Henry and Wilma’s children (or whoever else was named as beneficiaries) tax-free.
Now, assuming Wilma dies with all $2.5 million intact (the $1 million bypass trust plus the $1.5 million received outright under Henry’s will) and no additional assets of her own, the $1 million in the bypass trust passes directly to the children, tax-free. And, because Wilma never had full control over or an unfettered right to the trust’s principal during her lifetime, the trust’s assets are not included when calculating the value of her taxable estate. Next, her own $1 million exemption amount is deducted from the $1.5 million she inherited outright from Henry, leaving (assuming there was no additional estate planning) $500,000 subject to New York’s estate tax. The New York estate tax on $500,000 would be roughly $10,000.
However, had Henry left all $2.5 million to Wilma outright at his death, Wilma’s estate at her death would have been valued at the full $2.5 million, rather than $1.5 million. Her $1 million exemption amount would have been deducted from the $2.5 million, leaving $1.5 million subject to New York’s estate tax. The New York estate tax on $1.5 million would be roughly $64,400.
So, by setting up the bypass trust, Henry and Wilma were able to get the full benefit of their respective $1 million estate tax exemptions, thus getting $2 million to their children tax-free, and saving about $55,000 in estate taxes (while almost certainly spending less than 1/10th of that to set up their combined estate plans).
Annual Gift Exclusion
The annual gift exclusion allows any person to give up to $14,000 per year (as of 2013) to as many people as the donor wishes, tax-free—for both the donor and the recipient. This amount increases to $28,000 per recipient if given by a married couple. For example, you can give up to $14,000 (or $28,000 if giving as a married couple) to one person or a million people, tax-free. If you have twelve grandchildren, each can receive the full $14,000/ $28,000— every year, tax-free to you, tax free to them. If you want to give $14,000 to every resident of New York City, that’s fine, too—every year for as long as you’re alive. Tax-free. Thus, this is a great way to reduce the value of your estate by giving monetary gifts during your lifetime—to be enjoyed by the recipients while you’re still here, instead of only after you’re gone.
All of the above-mentioned estate planning tools can also be applied to reduce federal estate taxes, should your estate be large enough to be exposed to such taxes. Even if you don’t think your estate will qualify to be taxed under New York or New Jersey’s lower exemption amounts, your financial circumstances can change significantly at any time or over time, and so planning ahead now can save tens or even hundreds of thousands of dollars for your loved ones later. In addition, there are numerous tools other than those outlined here that can reduce your estate tax exposure even further.
Regardless of which type of estate tax you are trying to avoid or reduce, it is important to get sound advice from a knowledgeable attorney because in most cases the greater the potential benefit, the greater the scrutiny by the IRS and state taxation authorities—and the more technical and stringent the requirements for creating and administering a valid and enforceable trust or other estate planning instrument. Plus, a good estate planning attorney will stay abreast of and keep you informed about changes in the law, including the ever-shifting exemption amounts, so that you can sleep easy knowing that, when the time comes, as much of your hard-earned assets as possible will get to your loved ones, and in the way you intend for them to.