Understanding the Estate Tax

The federal estate tax, sometimes called the “death” tax, is a tax that is levied on the transfer of wealth in large estates. The application of this transfer tax is confusing and because of this, many unsuspecting taxpayers pay more estate tax than would have been necessary with proper planning. This article by Denver Estate Planning Attorney Brandon McDaniel explains how the estate tax is applied.

Why Tax Estates?

The first question many clients ask their estate planner is “why does the government tax my estate?” Indeed, the taxation of large estates can feel like an unfair punishment for a lifetime of success, or like the government is stealing what should go to your family. Estate taxation is an old idea that was in use even in ancient Egypt. In the United States, precursors to the modern estate tax date all the way back to the 1790’s, though such taxes have tended to come and go throughout U.S. history.

The modern rationale for taxing the transfer of wealth at death is not just to raise revenue, but to prevent the development of an American aristocracy. The theory goes that if we allow untaxed transfers of massive wealth from generation to generation, over time wealth will accumulate in the hands of a small number of aristocratic families leaving the rest of the nation dependent upon those families. Of course, there are many arguments against the taxation of wealth transfers and for this reason the estate tax remains in a constant limbo of reform. Regardless of the rationale, we must deal with the fact that there is currently an estate tax and it doesn’t look like it’s going anywhere.

Wealth Transfer at Death

Understanding the estate tax requires some understanding of the transfer of wealth. When someone passes away, their property will be transferred pursuant to the instructions of a will or trust, or if no such instrument exists the property will be transferred based on a set of default rules called the law of intestacy. Generally, when property is so transferred because of a death the recipient of the property does not incur any taxes on the receipt of the property. Instead, the estate of the deceased individual is potentially taxed on the transfer under through the federal estate tax.

The Estate & Gift Tax Lifetime Credit

Not every estate incurs the estate tax when property is transferred out of the estate because Congress has decided only very wealthy estates should incur the estate tax. To prevent middle class families from dealing with the estate tax, Congress has given each individual a credit (sometimes called the lifetime exemption) against the estate tax in a specific amount that changes each few years.

As of the writing of this article (November 2012) the lifetime credit allows a person to transfer up to $5 million over the course of their life free of estate or gift taxes. In essence this means you can give away up to $5 million in assets upon your death without incurring any transfer taxes. It’s important to note the lifetime credit amount is shared between lifetime gifts and transfers upon your death. If you make large gifts during your life, those gifts will use your lifetime credit and thereby reduce the credit available to you for transfers at death.

The Lifetime Credit in 2013

Because of uncertainty surrounding the fiscal cliff negotiations it is unclear what the lifetime credit will be in 2013.  As the law stands, the provisions that raised the lifetime credit to $5 million will sunset at the end of 2012, and in 2013 the lifetime credit amount will reduce to roughly $1.1 million. Such a scenario has never played out before so it is impossible to determine how such a reduction in the lifetime credit will affect those who have already used the full $5 million credit they have today.

Estate Tax Planning

The lifetime credit concept creates significant tax minimization opportunities for those who plan ahead. Using the marital deduction ( a tax rule that allows you to transfer unlimited amounts to your spouse without incurring taxes) in conjunction with a lifetime credit you can effectively double the amount that can be gifted or transferred at death without incurring taxes. This common type of estate plan is called A/B planning. If you expect to have an estate valued at more than $1.1 million you should contact an estate planning attorney to see if tax planning opportunities could benefit you.

Contact us today for more information on estate planning in the Littleton, Highlands Ranch and Denver Metro area.