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Understanding the Estate Tax

Updated on May 19, 2012

Estate Tax Basics

The Estate tax at both the Federal and State level is fairly complex topic. For the sake of this discussion, I will take a look at some fairly basic aspects that all Americans who have saved for retirement should be aware of to some extent.

First of all what is an estate tax ??? It is essentially a tax levied on the assets of a deceased individual. When you pass away your assets are totaled & a value is assessed on the estate. This is both your probate estate and your non-probate estate. In terms of the threshold at which point your estate is subject to Federal estate tax is a moving target. As of 2012 the individual exclusion is $5,120,000.00. The maximum amount of tax is set at a rate of 35%. This means the Federal gov’t will not tax the estate assessed at a value below that point. However, should the year 2013 reach us without any legislative changes, the number will revert back to $1,000,000.00.

For many of you reading this you may feel these numbers are so far beyond your net worth that why should you care. However, more people can and likely are impacted by this than most people realize. This stems from the fact that there is a great deal of confusion as to what exactly is your “taxable estate”. As mentioned earlier, your taxable estate is not just your savings account and the value of your home. It includes your investment accounts both retirement and non-retirement accounts. Although your IRA may have a direct beneficiary on it, this only serves to avoid the probate process with the courts. It does not however eliminate its value from your taxable estate. One of the more common misunderstandings among novice investors is how life insurance is treated. A life insurance policy is payable to your beneficiaries income tax free. However it is NOT estate tax free. This means if you currently have a life insurance policy with a 1 million dollar death benefit that you have personally purchased, as of 2013 (barring any legislative changes) you would have exhausted your maximum exclusion at death. That means all remaining assets you own will be potentially subject to a 35% tax before it is passed on to your heirs. It should be noted that assets that pass between spouses do so estate tax free if they are legally married.

How common is this ??? Well, for young individuals and couples for example that carry a sizeable mortgages it is fairly common to have a large life insurance policy to help alleviate the risk of death when one has minor dependents and outstanding debts. Perhaps you carry the insurance because you prefer to insure your child’s education should you meet with an untimely death. While your debts are netted against your assets, it is quite possible to see your assets exceed 1 million dollars when insurance is included. While statistically unlikely, if two parents were killed in an accident and left behind minor children, the combined life insurance policies as well as the loss of the spousal exemption can mean a sizeable tax bill to minor children. One common strategy is to use what is known as a life insurance trust or ILIT, whereby you have an irrevocable trust drafted that has its own separate tax id #. The trust exists outside your estate. Therefore the benefit paid to your heir’s remains income tax free. Since you personally did not own the policy, but rather the trust did, it is also exempted from your personal estate. Since the trust must exist until death, such an approach requires permanent life insurance which is substantially more expensive than term insurance. This strategy has become less common as the level of estate tax has risen to over 5 million per individual. Yet without congressional action before 2013, this may become far more common place again.

Additionally, the state you reside in may also have its own separate estate tax. In my state, which is NY, the threshold is already set at 1 million per estate. Some states can levy an estate tax well into the double digits. Other states have no estate tax. However they have an inheritance tax. This is effectively the same thing. It is a tax not on the deceased parties remaining assets but rather on the heirs at the point of inheritance.

There are numerous strategies that can be effective at eliminating or mitigating the impact of such taxes to your beneficiaries. This is a fairly complex topic and should not be taken lightly. It is always best to seek counsel with an attorney specializing in this field and have them work closely with your Financial Advisor. Estate decisions can also have an impact on an investment strategy as well as your long term health care planning. More importantly, stay on top of your plan. Unfortunately due to constant political change that effects policy decisions, the plan you have in place today can become antiquated in just a few short years.


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