Death, Taxes & Death Taxes

December 01, 2023

Ben Franklin once quipped there is nothing certain but death and taxes. Perhaps some bureaucrat at the IRS was thinking about that when they introduced the death tax in 1916. “Ah yes, death and taxes – those things really suck. Let’s combine them and levy a death tax. Death, taxes, and death taxes. Mwahahaha.” Probably something like that.

Run any compound growth calculator for a period of 100 years and you’ll find the magnitude wealth compounds over such a time horizon incomprehensible. 100 years really isn’t that long – my unborn grandchildren will be beginning to think about retirement in 2123. $1,000,000 compounding at 7%/yr. for 100 years? Your mind would be blown if I told you it would grow to $100,000,000. Well, it wouldn’t grow to $100M. It would grow to $867,716,325.57.

Incomprehensible.

Unfortunately, you can’t just let wealth compound for generations. Congress and the IRS dreamed up death taxes in 1916. Sure they gave it a benign sounding name – an “estate tax.” But it’s just a death tax. Sure, your income has been taxed every year and your property has been taxed every year and you pay sales tax whenever you buy food or medicine or anything else. Don’t think death is going to get you off the hook! You experienced the validity of Ben Franklin’s insight. You paid all those taxes. You died. Now Uncle Sam gets one last bite at the apple: the death (“estate”) tax. Most people don’t understand how the death (“estate”) tax works. It is overly complicated. Many people don’t think they need to worry about the death (“estate”) tax. Some are in for a rude awakening.

The two most important numbers/terms to be aware of are the federal estate tax exemption (“lifetime exemption”) and the annual exclusion. The numbers change most years as they are indexed for inflation and occasionally Congress passes some new law that completely changes them (sometimes rendering completed estate planning and gifting strategies obsolete). So it is important to keep estate planning and gifting strategies updated. We must keep the estate planning attorneys employed.

The federal estate tax exemption (“lifetime exemption”) is the total dollar amount an individual can leave behind without incurring any death (“estate”) taxes. In 2023, that number is $12,920,000. That number is portable for a married couple, so each spouse has an exemption level of $12,920,000 for a total of $25,840,000. When the first spouse dies all his assets are transferred to the surviving spouse. When the second spouse passes, she has a total exemption of $25,840,000, meaning she can leave behind $25,840,000 before incurring any death (“estate”) taxes.

If you ever hear the term “gift tax exemption” you probably find it sounds eerily similar to “estate tax exemption.” They are the same thing. This is why you may find “gift tax” and “estate tax” used almost interchangeably. Gift taxes apply to property transfers made when the grantor is still living; whereas death (“estate”) taxes apply to property transfers after the grantor has passed away. But it is the same tax and the same exemption. You get $12,920,000 to give away, whether you’re living or dead. You can’t simply gift all your property on your death bed to avoid the death (“estate”) tax - your lifetime exemption still applies. It’s just called the gift tax exemption if your heart is still beating. It’s all the same thing.

The easy way to think about it is you can bequeath up to $12,920,000 of your hard-earned wealth over the course of your life and at death before Uncle Sam sticks his finger in your balance sheet. If you are single and you pass away with a net worth of $13,000,000, then $12,920,000 will avoid the death (“estate”) tax, and the remaining $80K will be subject to death (“estate”) taxes. If the first spouse to die does not use any of his or her exemption while alive, and the second spouse leaves behind an estate worth $26,000,000, then $160,000 ($26,000,000 - $25,840,000) will be subject to death (“estate”) taxes.  That’s how the lifetime exemption works.

A quick note on death (“estate”) tax rates – they’re brutal. The tax schedule is marginal like the income tax but more pernicious. I won’t go through all the brackets here, but to give you an idea the first $10K is taxed at 18%, the next $10K at 20%, and the brackets keep moving up by about 2%. $100K - $150K is taxed at 30%, $750K - $1M is taxed at 39% and everything over $1M is taxed at a flat 40%. In total, the first $1M over the exemption amount incurs $345,800 in taxes and each $1M over that generates another $400,000 in death (“estate”) taxes.

One simple strategy for minimizing death (“estate”) taxes is taking advantage of the annual exclusion. That is the amount of money an individual can gift another individual each year without it counting towards their $12.92M lifetime exemption. In 2023 the annual exclusion is $17,000 (it will be $18K in 2024). That is, an individual can give up to $17,000 to an unlimited number of people without using a single dollar of their $12.92M lifetime exemption. Say you have three children and six grandchildren. You can give $17,000 to each child and each grandchild for a total of $153,000 ($17,000 x 9 children/grandchildren) each year. This is a simple and effective way to transfer assets out of your estate – you’ve removed $153,000 in one year without using a penny of your lifetime exemption. You also experience the psychological benefits of giving while you’re alive. Perhaps you make that $153,000 gift to those nine beneficiaries when you’re 70 years old and you expect to live to 90. If that $153,000 earns 7%/year, it will be worth $592,000 when you pass away at 90. Rather than eating into over $500K of your lifetime exemption at death, you’ve removed those assets from your estate and kept your entire lifetime exemption intact.

Further, a husband and wife can each use their own annual exclusion on the same beneficiary. In the same scenario above, a husband and wife can each give $17,000 ($34,000 total) to their three children and six grandchildren, removing a total of $306,000 from the estate ($17,000 x 9 x 2) in a single year. The compound growth of $306,000 over 20 years at 7% is $1,184,123. They have removed assets with a future value of over $1,000,000 without using any of their lifetime exemption simply by allowing them to grow and compound on the balance sheets of their heirs. Keep in mind this strategy can be repeated annually. It’s the annual exclusion. $17,000 may not sound like a substantial sum when dealing with a multimillion-dollar estate, but when spread between a few beneficiaries over a number of years a substantial portion of an estate can be transferred without any gift or death (“estate”) tax ramifications. Quick note: when spouses make a gift to a beneficiary between $17,000 and $34,000, it’s called a “split gift,” and they must file Form 709 with the IRS. For example, if a husband and wife give $20,000 to their daughter, filing Form 709 will clarify $3,000 doesn’t need to be applied to the lifetime exemption because it’s a split gift between husband and wife.

Suppose you and your spouse gift your daughter $40,000 this year. The annual exclusion will cover $34,000 of that sum (via a split gift), leaving $6,000 counting against the couple’s lifetime exemption of $25,840,000. As a result of the $40,000 gift this year, their lifetime exemption will decrease to $25,834,000 ($25,840,000 - $6,000). No taxes are due even though it exceeds the annual exclusion. It only decreases your lifetime exemption. Pretty much no one ever actually pays a “gift tax” – it simply decreases the amount of your assets that pass free of death (“estate”) taxes. You begin to see how gift and death (“estate”) taxes are intertwined. More gifts given while living (over and above the annual exclusion) means less left behind at death before assets are subject to death (“estate”) taxes.  

You will probably hear more about death (“estate”) taxes in the coming years. The estate tax exemption is high - $12,920,000/person is a lot of money. The Trump Tax Cuts & Jobs Act in 2018 doubled the exemption from $5,600,000 to $11,180,000 (the increase to $12.92M since 2018 is due to regular inflation adjustments). The Trump Tax Cuts are a temporary increase in the exemption. The tax provisions in that legislation sunset at the end of 2025. In 2026, we revert to the previous exemption level of $5,600,000/person ($11,180,000 for married couples) indexed for inflation – expected to be about $6,200,000 ($12,400,000 for married couples). Absent a (literal) act of Congress, the exemption will halve in 2026 meaning many families who do not currently have taxable estates will suddenly have taxable estates. This will lead to a flurry of estate planning adjustments that will quite annoy families with a net worth roughly between $12M - $25M (congratulations, you have death (“estate”) tax issues now!) but will probably keep estate planning attorneys busy and happy.

For those whose assets exceed the lifetime exemption (or will in 2026), there are numerous planning techniques to mitigate death (“estate”) tax liability in addition to utilizing the annual exclusion. They are beyond the scope of this post. But they are only effective when employed proactively with careful planning.

Sean Cawley, CFP®

*I have taken great pains to avoid calling death taxes merely by their benign name (“estate taxes”) in this post. Hopefully you were not too annoyed by the repetitious notation “death (“estate”) taxes.” We should call things what they are. It is a tax levied on your assets simply because you are no longer breathing. A death tax.

 

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