Getting Down to Basics: Estate and Gift Taxes
You work hard, save, and take care of your money throughout your life. Therefore, you also need a good plan in place for estate taxes and inheritances to ensure your money goes where you want it to after you pass on.
Follow along below to better understand the basics of how estate and gift taxes work.
What is an Estate Tax?
An estate tax is a tax imposed by the federal and some state governments on the value of property that passes from a person who dies (referred to as a decedent) to the decedent’s beneficiaries by reason of his or her death. The federal estate tax applies to the transfer of property at death and is imposed at the estate level, not on the individual beneficiaries.
What is a Gift Tax?
Congress enacted the gift tax in 1924, repealed it in 1926, and reintroduced it in 1932 to prevent donors from avoiding the estate tax by transferring their wealth before they died. A gift tax is imposed by the federal government on the value of property that a person gives to his or her beneficiaries while he or she is living. However, the tax is only imposed in the event gifts exceed the annual exemption amount (the Federal annual gift tax exemption is presently $15,000 per person for 2020).
Note that if you exceed the annual gift tax exemption amount, you can avoid any gift tax obligation by using up a portion of your lifetime exemption. Massachusetts, Rhode Island, and New York do not have a gift tax while Connecticut recently increased its gift tax exemption amount to $5.1 million. A Connecticut resident will not owe gift tax unless the gifts provided to beneficiaries over time exceed the exemption amount.
What is an Inheritance Tax?
An inheritance is a state tax that you pay when you receive money or property from the estate of a deceased person. Unlike the federal estate tax, the beneficiary of the property received is responsible for paying the tax, not the estate. The federal government has an estate tax, not an inheritance tax. Massachusetts, Connecticut, New York and Rhode Island each have an estate tax, not in inheritance tax. The six states that impose an inheritance tax presently include Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania.
What is a Generation Skipping Transfer Tax?
Congress enacted the generation skipping tax (GST) tax in 1976 to prevent families from avoiding the estate tax for one or more generations by making gifts or bequests directly to grandchildren or great-grandchildren. The GST tax effectively imposes a second layer of tax – using the exemption and the top tax rate under the estate tax – on wealth transfers to recipients who are two or more generations younger than the donor. For example, a gift to a grandchild constitutes a GST.
What is an Estate, Gift and Generation Skipping Transfer Tax Exemption?
An estate tax exemption amount is the total amount of funds and property that a decedent can leave to their beneficiaries without incurring an estate tax.
A gift tax exemption is the total amount of funds and property a person can give to their beneficiaries while living without incurring a federal gift tax. Gifts made during life that exceed the $15,000 per donee annual federal gift tax exclusion reduce the amount of estate tax exemption available at death.
A generation skipping transfer tax exemption is the amount of funds and property a person can transfer during life or after death without incurring a federal generation skipping transfer tax.
What are the 2020 Federal and Massachusetts Estate Tax Exemptions, Exclusions, Deductions and Tax Rates?
The 2020 Unified Federal Estate, Gift and Generation Skipping Transfer Tax Exemption for U.S. Citizens and Residents is $11,580,000. The executor of an estate must file a U.S. Estate Tax Return within nine months after the death of the first spouse of a married couple. A “portability” feature provides that the unused exemption of the first spouse can be used by the estate of the surviving spouse. This can have the effect of giving a married couple a total combined exemption of $23,160,000. The use of a credit shelter trust is a way of capturing the exemption of the spouse who is first to die without electing portability within nine months after death
This exemption is reduced by lifetime gifts in excess of the annual exclusion.
2020 Federal Estate, Gift and GST Tax Rate
The tax rate on the value of an estate that exceeds the exemption is 40%. The estate tax applies to a decedent’s gross estate, which generally includes all the decedent’s assets, both financial (e.g., stocks, bonds, and mutual funds) and real (e.g., homes, land, and other tangible property). It also includes the decedent’s share of jointly owned assets and life insurance proceeds from policies owned by the decedent.
The estate and gift taxes allow an unlimited deduction for transfers to a surviving spouse, to charity, and to support a minor child. Estates may also deduct debts, funeral expenses, legal and administrative fees, charitable bequests, and estate taxes paid to states. The taxable estate equals the gross estate less these deductions
A credit then effectively exempts a large portion of the estate: in 2020, the effective exemption is $11.58 million. Any value of the estate over $11.58 million is generally taxed at the top rate of 40% as mentioned above.
2020 Massachusetts Estate Tax Exemption: $1,000,000
This exemption is reduced by lifetime gifts in excess of the federal gift tax annual exclusion.
2020 Massachusetts Estate Tax Rates: 0.8% to 16%
Depending on the value of the estate. Unlike the federal estate tax, the Massachusetts estate tax is imposed on the entire value of the estate if the exemption is exceeded.
2020 New York Estate Tax Exemption: $5,850,000
The New York basic exemption amount is $5,850,000 (indexed for inflation). For 2020, New York also implemented a rule precluding certain estates from taking advantage of that exclusion at all. If the amount of your taxable estate is more than 5% over the exclusion amount at your death, you cannot take advantage of New York’s exclusion. You essentially “fall off the cliff” if your taxable estate is too high. These estates are subject to New York estate tax in their entirety – starting from dollar one.
For example, imagine an individual died today, when the New York estate tax exclusion amount is $5,850,000. If that individual died with a taxable estate of $6,200,000, then his entire estate would be subject to New York estate tax, since $6,200,000 is more than 5% higher than $5,850,000. This would result in a New York estate tax rate of over 100% on the amount by which the estate exceeds the exclusion amount. Given these rules, it is important to plan for these so-called “cliff” provisions by having an appropriate personal estate plan that addresses these unique circumstances.
2020 New York Estate Tax Rates: 3.06% to 16%
Depending on the value of the estate. The top rate of 16% only applies when the New York taxable estate is over $10,100,000. Dollars below that amount are subject to estate tax at graduated rates, starting at 3.06% for the first $500,000, subject to the New York state “cliff tax” rules
2020 Federal Gift Tax per Donee Annual Exclusion for U.S. Citizens and Residents: $15,000
This is the aggregate number of gifts that an individual can make during each calendar year to another person without using part of their $11,580,000 lifetime federal estate, gift and GST tax exemption. Note there is no limit on the number of $15,000 gifts that can be made to other individuals in a calendar year – just a $15,000 limit per recipient.
2020 Federal Estate and Gift Tax Marital Deduction for U.S. Citizens: Unlimited Deduction
2020 Federal Estate and Gift Tax Charitable Deduction: Unlimited Deduction