Federal and state death taxes – and exemptions
After your death, your family may be liable to pay Federal estate tax and state inheritance tax. These taxes are in addition to any expenses you may have to pay such as probate and legal fees and, under current Federal law, can be between 41-55% of every dollar of your estate over the exemption thresholds outlined below. “death taxes” are often referred to as “estate taxes.”
The Federal death tax
After your death, the Federal government allows your beneficiaries to receive up to $5,340,000 (indexed for inflation) without paying death taxes. Every dollar above that will be taxed unless there is a plan in place before your death to avoid high death taxes.
Massachusetts death (estate) tax
Many estates that do not owe Federal estate tax nevertheless will owe Massachusetts estate tax. This is because the amount that passes tax-free for Massachusetts’ purposes is much less than what passes tax-free under Federal law. The reason is that the Federal estate tax exemption currently is $5,340,000 per person, while the Massachusetts exemption is only $1,000,000. So, although the estate of a Massachusetts resident having a $5 million estate will pay zero Federal tax, the same estate nevertheless may owe a substantial Massachusetts tax. The Massachusetts estate tax applies to all estates of Massachusetts residents. The $1,000,000 Massachusetts exemption is a filing threshold. That is, a Massachusetts estate tax return must be filed – even if no tax is actually due – for any Massachusetts decedent whose “gross Estate” (the gross value of all property owned at death or the ownership of which otherwise legally is attributed to the decedent) exceeds $1,000,000.
Estate tax and marriage
When one spouse passes, no estate tax is required to be paid to either the Federal government or the Commonwealth of Massachusetts. This exception is called the “Unlimited Marital Deduction” because no matter the size of the estate, a surviving spouse will not have to pay death taxes after their spouse dies.* This is important in the short run, but in the long run, death taxes will catch up to the family. When the last living spouse dies and the estate passes to his or her beneficiaries, the taxes will be due, perhaps even at a higher rate if the estate went up in value.
* This Unlimited Marital Deduction applies only if the surviving spouse is a U.S. citizen. If not, entirely different rules apply.
Planning for a small estate
Even if you have a small estate that would be exempt from Commonwealth of Massachusetts death taxes (if it’s worth less than $1,000,000), you may still be forced to go through Living Probate or Death Probate (or both). Proper estate planning cannot only save you on potential estate taxes, but it can also help your family prevent the heavy time and financial burdens of probate court.
Reducing Your Massachusetts Estate Tax Burden
If you are a Massachusetts resident (or couple) with virtually no chance of having an estate worth over $1 million, you can skip ahead to the next section. But if there’s any chance that your estate will be valued at over $1 million, then you should keep reading to learn how to reduce the estate tax burden. There are three general approaches available (besides simply paying the tax).
Spend Your Money and Give Gifts
Gifts of up to $14,000 per year are not taxed. Through advanced planning, you can do piecemeal annual transfers of assets to save your loved ones some tax expenses in the long run. For example, assume Michelle owns a home worth $500,000, and has $250,000 in investments and savings, plus another $250,000 in assets in an IRA. Taking money from her savings investments could be detrimental for Michelle’s financial security. She could, however, transfer an interest in his home to his children in $14,000 annual increments.
Unfortunately, that strategy would not be advisable if the house had significantly appreciated since Michelle bought it due to the lifetime gift and capital gains tax consequences. In that circumstance, Michelle could accelerate her IRA distributions instead. IRA withdrawals are taxable income. If there is anything left in the IRA upon her death, those funds are passed onto Michelle’s children and will be taxed based on their individual tax brackets. If Michelle successfully reduced her estate to under $1 million with this adjustment, around $35,000 in estate taxes would be avoided entirely. (To be fair, we would expect the accelerated distributions to result in some lost earnings in the IRA, but on balance, the result should be a significant savings.) This way, Michelle gets the benefit of spending more of his money however he wants during his life, while still saving responsibly and ensuring that his heirs are not taxed unnecessarily.
Create a Trust for the Surviving Spouse (Couples Only)
Money passing from a deceased spouse to her surviving spouse is not taxed. But if that money remains in the surviving spouse’s estate upon his death, it will be taxed then. If the surviving spouse does not need the money, the couple can plan to avoid this by passing enough assets to others (e.g., their children) so that the surviving spouse’s estate remains below $1 million. This tactic works only up to a point, however—if you give away over $1 million to other people, the estate will have to pay a tax anyway.
Alternatively, the surviving spouse may refuse or disclaim some of the money. In that situation, the money, like any other property, would typically pass onto the children. This approach may require difficult calculations at a difficult time, which is one reason why most clients opt for the third option: structuring the estate to have assets pass directly into a trust set up for the benefit of the surviving spouse. Such a trust would provide income for the surviving spouse during life without the remainder being taxed upon his death. Again, this requires advanced planning with trusted counsel.