Understanding Estate, Inheritance, and Income Taxes - Does It Affect You?
One of our clients' concerns is that when they pass on, how much will the Federal Government and their State Government take from their estate as they try to pass on assets to their loved ones, particularly their children and grandchildren? As a team committed to being a world-class holistic wealth management team , estate and legacy planning is one of the five pillars of financial planning, and we need to know the laws to think ahead and do advanced planning. So much of estate and legacy planning is integrated and overlaps with tax management. To us, they are inextricably linked together. This topic is so deep and has so much information. For this article, let’s talk about some basics. When it comes to estate planning and tax management, there are three potential taxes of which you need to be aware:
1. Estate Tax – When individuals or couples pass away, federal and state governments believe that, above a certain level of wealth, the government should receive a percentage above a threshold. The Federal Estate tax exemption for 2024 is $13.6 million for individuals and $27.2 million for couples (provided they do advanced planning in advance using trusts and other tools). Based on these numbers, that does not affect many of you, and as a result, you will not pay estate tax. However, if it does affect you, every dollar above that level could be taxed at 40% Federal and 20% State tax (depending on the state). As simple example, say you as individual are worth $24 million, the first $13.6 million would be exempt from estate tax. The other $10 million could be subject to $6 million in taxes. There are two big caveats to this: (1) Many states match the federal estate tax level, but there are some whose limits are significantly lower and as low as $ 1 million. That is why it is important to know your state’s specific estate tax laws. (2) The federal limit is set to sunset at the end of 2025 and be lower to $5 million. As a result, this may affect more of you.
What is in your estate? It is assets that are in your name. Money in the bank, investment accounts, property, and valuables. Several solutions we are talking about to our clients who do not want so much of their estate eaten with estate taxes: (1) gifting strategies while they are alive, (2) use of charitable planning and trusts, (3) using more permanent life insurance what they call 2nd to die so that money is available to pay estate tax for the heirs (4) legacy planning where certain assets are left to charities while using permanent life insurance that is left to heirs outside of the estate.
2. Inheritance Tax – This is separate from estate tax and can be confusing because it is very similar to estate tax. This is more at the state level, where one has to work with wealth managers, attorneys, and accountants who understand the state-specific laws. Since we are located in Maryland and next to Pennsylvania, inheritance taxes can affect many of our clients. For Maryland, inheritance tax does not apply if one leaves assets to a spouse, their kids and grandkids, parents, siblings, and step-children. What this means is if leaving money to nieces, nephews, and friends, there is an inheritance tax. If you are a Pennsylvania resident, an inheritance tax applies to everyone except the spouse. Therefore, an inheritance tax leaves money to your kids, grandkids, siblings, and others.
Similar to solutions with estate tax, we are discussing similar strategies used in estate tax planning.
3. Income Tax – Even if you leave your assets to your kids and grandkids and are not subject to estate tax and inheritance tax, there still may be substantial taxes that your kids and grandkids may pay. This area is for many of our clients whose estates are over $ 1 million. For many of our clients, the single most significant asset class, particularly their liquid assets, is money they have in pre-tax retirement accounts: Individual Retirement Account (IRA), 401k, 403B, Thrift Savings Plan (TSP), 457. We were all told to max these accounts out. If the kids and grandkids inherit these based on the SECURE Act signed into law in 2019, they must liquidate within ten years after they inherit from Mom or Dad. In a recent training, Ed Slott, CPA, and preeminent IRA expert, said that pre-tax accounts are the worst asset class to pass on to the family.
Solutions we are discussing now are (1) Roth conversions of money in pre-tax, (2) Switching contributions in retirement to pre-tax within the 401k to Roth option within 401k, (3) Drawing more heavily on pre-tax accounts to meet retirement needs compared to post-tax and tax-advantaged Roth (4) funding Life Insurance Retirement Plans (LIRPs) for tax-free income that will be left to kids tax-free. (5) Taking distributions from pre-tax IRAs and funding permanent life insurance that goes to kids tax-free and, in some cases, estate and inheritance tax-free.
We want to serve you better and help give you financial security. We are committed to being world-class in holistic wealth management. We want to create an integrated plan for you that thinks generationally and goes beyond your life. We want to be tax-conscious because taxes are the single biggest expense you have in retirement, and most likely, your heirs will have as well. We may not completely eliminate taxes, but we want to mitigate them. If you have any questions, please let us know.