Knowing the tax rules can help you pass on more of your money to your loved ones while minimizing taxes. The majority of people don’t need to worry about estate and gift taxes — fewer than one out of every 1,000 estates owed federal estate tax in 2018, according to the Center on Budget and Policy Priorities. But if you are wealthy and hope to transfer wealth to future generations, you should understand how the IRS might try to take a share. After all, the less you and your estate pay in taxes, the more money will be available to improve the long-term financial security of your family.
A well-crafted estate plan can help you meet your goals while minimizing your tax liability. It’s important to understand the three types of taxes that the IRS levies on gifts and inheritances.
Federal and State Estate Taxes
Relatively few families have to worry about paying federal estate taxes. For 2022, the estate tax exemption is $12.06 million. It jumps to $12.92 million for 2023. For estates valued above those limits, the tax rate is 40 percent on the assets above the threshold. However, 12 states and the District of Columbia levy taxes on their residents’ estates.
Those taxes range from 0.8 percent to 20 percent, and come on top of any federal estate tax. Some states have a lower exemption threshold than the federal limit, with some starting as low as $1 million. In these cases, an estate that isn’t big enough to trigger federal estate taxes might still owe estate taxes at the state level. Six states currently charge an inheritance tax (between 10 percent and 18 percent) on residents who receive a bequest. The tax is payable by the beneficiary, as opposed to estate taxes which are paid by the estate. Fortunately, spouses typically are exempt from that tax, and family members often pay less or also receive a full exemption.
Federal Gift Taxes
Taxpayers who think they might end up with an estate large enough to trigger estate or inheritance taxes can give away some assets now to reduce that tax exposure. For 2022, the federal government allows individuals to make tax-free gifts of up to $16,000 in cash or assets to as many people as you like each year ($17,000 for 2023).
For example, a couple might each give away $16,000 to each of three children, creating a tax- free transfer of $96,000 to the next generation ($16,000 x 3 children x 2 individuals = $96,000).
What’s more, the couple could repeat those transfers every year for as long as they had assets they wanted to pass along to their beneficiaries. Over time, these gifts could significantly reduce the size of their estate before it might be subject to an estate tax, thus creating a cost-effective way to avoid a potentially costly estate tax bill, and allowing their heirs to enjoy their assets while their parents are living.
If you give more than $16,000 to one person in a single calendar year, you won’t suffer any immediate tax consequences. However, gifts that exceed the $16,000 annual gift tax limit do count against your individual estate tax limit of $12.06 million in 2022. For example, if you give $20,000 to each of three children ($4,000 more than the limit), your federal estate tax exemption would decline by $12,000. For that reason, planning ahead can allow you to transfer enough assets to avoid estate taxes, despite the annual gifting limits.
The Generation-Skipping Transfer Tax
Some individuals with large enough estates to be concerned about the estate taxes choose to leave some or all of their assets directly to their grandchildren, skipping one round of estate taxes. Otherwise, the money would be taxed when they leave it to their children — and then again, when their children leave it to the third generation. A generation-skipping transfer isn’t free, however; it’s subject to a generation skipping transfer tax (GSTT). For 2022, you can transfer up to $12.06 million ($24.12 million as a couple) to your grandchildren before a 40 percent tax applies to the estate.
A version of this article appeared in our partner magazine, The Essential Tax Guide: 2023 Edition.