Estate planning is a critical component of being financially prepared, especially for individuals with significant assets. Understanding how taxes impact the transfer of wealth is important to ensure your assets are distributed according to your wishes while minimizing potential tax burdens on your heirs.
In this blog, our Lewis CPA team explores the key differences between estate taxes such as inheritance tax and gift tax. Along the way, we’ll provide insights into how each tax affects your estate planning decisions and offer guidance on strategies to mitigate potential tax liabilities.
What Is an Inheritance Tax?
Inheritance tax is a federal tax levied on the transfer of assets from a deceased person's estate to their beneficiaries. This tax applies to the value of the estate exceeding a certain exemption amount.
Let's look at key aspects of inheritance tax:
- Taxable amount: The taxable amount is the value of the estate exceeding the federal estate tax exemption.
- Taxpayer: The executor of the estate is responsible for paying the inheritance tax.
- Exemption: The federal estate tax exemption changes annually. In 2024, the exemption is $13.46 million per person. This means estates valued at $13.46 million or less are not subject to federal estate tax.
- Valuation: Assets are valued at their fair market value on the date of death. This can include real estate, investments, bank accounts, personal property, and business interests.
Federal Inheritance Tax Calculation
Here’s an example of how to calculate inheritance tax: A person dies in 2024, leaving an estate valued at $15 million.
- Exemption: The federal estate tax exemption in 2024 is $13.46 million per person.
- Taxable estate: $15 million (total estate) - $13.46 million (exemption) = $1.54 million (taxable estate)
- Tax rate: The federal estate tax rate for 2024 is 40% on the taxable amount.
- Tax liability: $1.54 million (taxable estate) x 0.40 (tax rate) = $616,000 (federal estate tax).
Note: These calculations are simplified examples to illustrate the tax implications.
What Is a Gift Tax?
A gift tax is a federal tax imposed on gifts exceeding a certain threshold given away during a person's lifetime.
Let’s look at the key aspects of gift tax:
- Taxable amount: The taxable amount is the value of the gift exceeding the annual gift tax exclusion.
- Taxpayer: The person making the gift is responsible for paying the gift tax.
- Annual exclusion: In 2024, the annual gift tax exclusion is $17,000 per person per recipient. In other words, you can give away up to $17,000 to an individual without incurring any gift tax.
- Lifetime exemption: You can gift up to $13.46 million during your lifetime without incurring gift tax (as of 2024). This exemption is combined with the estate tax exemption, so using it reduces the amount available for estate tax later.
- Valuation: Gifts are valued at their fair market value on the date of the gift. This includes cash, real estate, securities, artwork, and other valuable assets.
Federal Estate Tax Calculation
Let’s check an example of gift tax calculation: A person in 2024 gifts $2 million to their child in a single year.
Federal estate tax calculation:
- Gift taxable amount: Since the total gift ($2 million) is less than the lifetime exemption ($13.46 million), there is no taxable gift amount.
- Federal gift tax due: Because there's no taxable amount, the federal gift tax due is $0.
Note: These calculations are simplified examples to illustrate the tax implications.
Understanding the Key Differences: Gift Tax vs. Inheritance Tax
While both inheritance tax and gift tax are levied on the transfer of wealth, they differ significantly in their timing, application, and potential impact on your estate plan.
When Is Gifting a Better Option than Inheritance?
While inheritance allows for complete control over asset distribution until your death, gifting offers several potential advantages:
- Reduced estate tax liability: Gifting assets during your lifetime reduces the taxable value of your estate, potentially avoiding or minimizing inheritance tax upon your death.
- Early access to wealth: Gifting allows your beneficiaries to benefit from the assets during your lifetime, providing them with financial flexibility and potentially helping them achieve their goals sooner.
- Potential investment growth: Gifting assets allows your beneficiaries to control and invest them, potentially leading to greater returns than if the assets were held in your estate.
When Is Inheritance a Better Option than Gifting?
While gifting can offer tax benefits and provide early access to wealth for your beneficiaries, inheritance also has advantages:
- Maintained control: You maintain complete control over your assets until your death to ensure their distribution aligns with your wishes.
- Avoiding gift tax: You avoid any gift tax obligations when leaving assets to beneficiaries through inheritance.
- Flexibility: You can adjust your estate plan until your passing, modifying beneficiaries or asset distribution based on changing circumstances.
Strategies for Minimizing Gift & Inheritance Taxes
Understanding the differences between inheritance and gift tax can inform your estate planning strategies to minimize tax liabilities and maximize the transfer of wealth to your heirs.
- Utilize the annual exclusion: The annual gift tax exclusion provides an opportunity to transfer wealth gradually over time. You can use this to give $17,000 per person each year without incurring any gift tax. This strategy allows you to reduce the taxable value of your estate while potentially providing your heirs with early access to assets.
- Consider charitable giving: Donating assets to qualified charities can reduce your taxable estate. Charitable contributions are often deductible for income tax purposes, and gifts to charities aren’t typically subject to gift tax.
- Explore trust strategies: Trusts can be used to transfer assets while maintaining control over their management. For example, a revocable living trust allows you to control your assets during your lifetime and distribute them to your beneficiaries upon your death.
- Gifting appreciated assets: Gifting appreciated assets can help avoid capital gains tax on their sale by your heirs. When inherited assets are sold, the heir receives a step-up in basis to the fair market value at the time of death, potentially avoiding capital gains tax. However, when gifting appreciated assets, the donor generally doesn’t receive the step-up on a basis.
- Gifting partial payments: Consider gifting partial payments of larger assets. For example, instead of giving an entire piece of real estate, you could gift a percentage or a specific share of the property. This can help reduce the value of a single gift and minimize potential tax implications.
Important note: On November 26, 2019, the IRS clarified that individuals taking advantage of the increased gift tax exclusion amount in effect from 2018 to 2025 will not be adversely impacted after 2025 when the exclusion amount is scheduled to drop to pre-2018 levels. The regulations implement changes made by the Tax Cuts and Jobs Act (TCJA), tax reform legislation enacted in December 2017. This clarification provides certainty and peace of mind for those who have utilized the increased exemption amount for gift-giving.
Expert Estate Planning: Get the Right Advice from Lewis CPA
Navigating the complexities of inheritance and gift tax requires a comprehensive understanding of applicable tax laws and financial planning principles. We highly recommend consulting with a qualified financial advisor, such as ours at Lewis CPA. Our team of experienced professionals can provide personalized guidance to help you develop a comprehensive estate plan that aligns with your financial goals and minimizes potential tax liabilities.
Let us help you navigate the complexities of wealth transfer and ensure your legacy is protected. Reach out to us today for a free consultation.
