The ultimate guide to death and taxes

Just do this: Today, the Federal government allows every individual to pass on up to $5.6M tax free over the course of their lifetime. If you don’t expect your estate to be worth more than that amount (inflation adjusted) when you die, then your best strategy is to wait until you pass away so all your assets pass through your estate tax free. Your heirs will benefit from a step-up in basis of any assets you pass on, saving them from potentially large capital gains taxes. But, if your estate is worth more than $5.6M (inflation adjusted), you’ll be hit with a 40% tax on anything over that amount. If that’s the case, you’ll want to start exploring options to pass on assets tax free while you’re still alive. Getting married is one way to double your gifting power (assuming your spouse doesn’t have an equally large estate). The other strategy is to gift up to the max annual gift tax exclusion every year to as many heirs as you see fit. Together these strategies might help you shelter an additional $25M in assets from estate tax. Lastly, be wary of states that impose estate and inheritance tax – they are uncommon, but a big pain if it bites you in the ass. Oh… and if your estate is valued in the hundreds of millions or billions, this note won’t help you much. It will likely take some more complex strategies to shelter that much wealth. Of course, that’s a pretty good problem to have, and I’m sure you can afford to buy some good advice to help you with it. Enjoy!

Nobody likes to think about their own mortality, but unless we somehow cure aging and the corresponding disease that come with it, dying is something we will all face. When it comes to finances, your death, or the death of a loved one, can have some major implications. Below is a good primer on the key things to consider when planning your estate.

Will you be worth more than $5.6M when you die?

The first question to ask when planning your estate is how much you will be worth when you die. This is important because the government lets you pass on a certain amount of assets tax free (this is called your lifetime gift tax exclusion). If the amount you’re passing on is lower than the lifetime gift tax exclusion, then you don’t need to worry about estate planning as much, because it will pass to the next generation tax free. But if you’re above that bar, you’ll be hit with a 40% tax on every additional dollar.

So… let’s answer a few questions:

  • When will I die?
  • What will I be worth when that happens?
  • How much will the government let me pass on tax free?

When will I die? If you’re 35 today, you might reasonably expect to live to 77 if you’re a man, or 81 if you’re a woman. Of course, if you want to get more precise, certain lifestyle choices can affect your odds. There are a range of life expectancy calculators. The best one I’ve found is the Wharton Calculator, which told me I have a 75% chance of living to 90 with a life expectancy of 98. Not bad.

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What will I be worth when that happens? Your net worth calculation should include all your assets – stocks, real estate, businesses, and even life insurance payouts. You can check out my Lifetime Earnings Calculator (email me if you have trouble requesting access) to figure out how much you’ll be worth at that time. I realize the calculator only forecasts 30 years at this point, so depending on your age you might need to run things for 30 years, then reset the calculator starting at a higher age with the results from the previous run as starting inputs. This should help you get a ballpark idea of how much you’ll be worth in your later years.

How much will the government let me pass on tax free? If you know your life expectancy, you can take a guess at how much the government might reasonably let you pass on tax free when you die. In 2018, the Federal government will let an individual pass on $5.6M over the course of their life. Their intent is to continue increasing that limit with inflation. If you’re 35 today and expect to live to 90, the lifetime limit per individual could grow to $12.7M (assuming a modest 1.5% inflation rate – see my Death and Taxes Worksheet to play with assumptions yourself).

If you’re married, you’ll be glad to know that you can pass on all of your estate to your spouse tax free. In addition, you and your spouse can combine your lifetime gift tax exclusion (just make sure you pass your exclusions on to each other properly by electing portability of the exclusion). So as a couple today, you could theoretically pass on $11.2M tax free. Using the future $12.7M estimate for the individual gift tax exclusion (referenced above), that could potentially be $25.4M by the time you pass away.

Note: In 2018 there is a short-term increase in the lifetime gift tax exclusion taking it to $11M, but that is set to expire in 2025, so don’t count on it. Better to plan for the $5.6M adjusted for inflation.

What if your end of life assets will be LESS THAN the lifetime gift tax exclusion?

If your expected end of life net worth is less than the expected future lifetime gift tax exclusion (this is true for the vast majority of people), then the best thing for you to do is to wait until your death to pass on your wealth. This is because passing on assets in this way will have two benefits:

  1. Those assets will pass tax free from you to your children – no federal estate tax
  2. Your children will receive a ‘step-up’ in the basis of the assets (all types, including stocks, real estate, businesses), meaning your heirs can avoid substantial future capital gains taxes

What this also means is that you want to minimize the gifts you give while you’re alive, because gifts given before death, while potentially given tax-free, will not benefit from the ‘step-up’ in basis. This means your children will end up owning those assets with the cost basis you paid for them, which will likely result in significantly higher capital gains tax if / when they sell in the future. You’re much better off letting the assets grow in your accounts and pass down through your estate.

This is particularly useful for real estate, because you depreciate the value of the property over time. Using the 1031 rule, you can keep rolling that depreciation into future assets you purchase, and avoid paying depreciation recapture your entire life. When you pass on your real estate, the stored up depreciation recapture is wiped out when the property basis is reassessed.

What if your end of life assets will be GREATER THAN the lifetime gift tax exclusion?

If you expect your end of life assets to be greater than the lifetime gift tax exclusion, you will want to start thinking through ways to pass on more of your wealth while you are still alive. Upon death, any dollar of your estate over the lifetime gift tax exclusion will get hit with the Federal estate tax (currently set at 40%). Here are some of the better ways to pass on your money before it gets hit with the estate tax:

Double your exclusion by getting married

As mentioned above, spouses can combine their lifetime gift tax exclusions together. This will double the amount you can pass on. Just make sure the ‘portability’ of the estate tax exemption is passed on properly upon the death of the first spouse, so that extra gifting limit can be used fully.

Annual gift tax exclusion

Every year the IRS lets you gift a certain amount without it counting toward your lifetime gift tax exclusion. Each spouse can gift up to $15K / year to any number of beneficiaries – children, grandchildren, relatives etc. This can add up pretty fast. If you have two children, and they each have two children, that totals 6 individuals who you can give $15K completely tax free. Your spouse can do this too. This means in 2018 you and your spouse can give $30K tax free to any person you want. Assuming you have six relatives you want to give to, that’s $180K per year. Over a 30 year timeframe, that adds up to more than $7M in tax free gifts.

If you’re going to make gifts to children, grandchildren or their spouse, just make sure those gifts are truly meant for the recipient, and managed that way – a word of warning:

…the IRS went after the estate of a man who had given annual gifts of stock to his son, daughter-in-law, and grandchildren, classifying each gift as exempt because of the annual gift tax exclusion. For 14 years, the daughter-in-law had faithfully transferred her stock to her husband on the same day she received it. The IRS ruled that the stock was really for the son, and that the gifts to him had exceeded the annual exclusion amount.

The best form for these gifts is cash on hand. But, if you need to sell assets to make the gift, then you’re better off gifting the assets themselves, as you can avoid incurring any capital gains tax today. Your heir won’t get the benefit of a step-up in basis, but they can hold onto those assets indefinitely without selling and incurring a capital gain. Also, if they sit in a lower tax bracket, it would make a lot more sense to gift the assets to them, and let them sell the assets to incur the capital gains tax themselves.

5-year contributions into 529 plans

Another way to gift is through a 529 college savings plan. This can be a great way to give as it lets the gift grow tax free, and any gains can be used tax free when spent for educational purposes. Any 529 gifts will be counted toward your annual gift tax exclusion, and if you exceed the annual limit, it will count toward your lifetime gift tax exclusion.

One neat trick with 529 plans is that you can contribute 5 years worth of annual gift tax exclusions in a single year. This requires a special election and proper filings on form 709 with the IRS.

Pay for qualified medical and tuition expenses directly

Qualified medical and tuition expenses can be paid directly by a donor without any tax implications. The only catch here is the expenses must be paid directly – can’t give to the beneficiary and have them pay the expense.

Cover the cost of a family trip… ?

Sorry. Technically, this will be treated the same way as just giving your family cash. If you cover the cost of a vacation it will be counted toward your annual gift tax exclusion, and / or your lifetime gift tax exemption.

A few other housekeeping items…

In addition to the advice above, there are a few other things to watch out for.

State estate taxes: Make sure you die in the right state

Most states do not impose estate taxes when you die. But not all of them are this generous. Certain states collect estate tax, often in the 15-20% range, with lower exemption levels than Federal estate tax. For example: If you die in Oregon, any value over $1M will start getting taxed at 10%, and maxing out at 16% for anything over $9.5M.

State inheritance taxes: Make sure your beneficiaries are living in the right state

In addition, certain states impose inheritance tax – a tax on the person receiving the inheritance. This is uncommon, and in most cases they provide partial or full exemptions for spouses and direct descendants. But it can be a big pain if you somehow receive a windfall from a distant relative and have to pay a chunk of it to the state. For example, in Nebraska:

  • Immediate relatives are subject to an inheritance tax of 1%
  • Remote relatives are subject to an inheritance tax of 13%
  • Other transferees are subject to an inheritance tax of 18%

Watch out for the ‘generation skipping transfer tax’ (GSTT)

Lastly, watch out for the dreaded generation skipping transfer tax. The idea here is that the Federal government expects you to pass on your estate to your children – they don’t want you skipping a generation and passing it directly to grandchildren. To remove the incentive to pass your estate down multiple generations, they will simply tax you the same amount that would have been incurred ‘as-if’ you passed it to your children, and they passed it to their children. A few example explain this best:

Example 1: In 2015, when the GST tax rate was equal to 40%, a grandfather, who had used up his gift and GST tax exemptions in prior gifts, gave his granddaughter $1 million. He must pay a gift tax of $400,000 and the GST tax of $400,000 plus a GST tax on the amount of the gift tax paid, which is 40% of $400,000, or $160,000, for a grand total of $960,000. Hence, the grandfather must pay a total of $1,960,000 so that his granddaughter can receive $1 million!


Example 2: In 2015, when the lifetime exemption amount for all transfer taxes is $5,430,000, Paul, who has not previously used any exemption credit, gives his granddaughter $10,000,000. The 1st $5,430,000 is exempt from gift taxes because of the unified credit and is also exempt from GST tax, using the GST credit. However, the remaining value incurs both a gift tax and a GST tax. Paul dies in 2012 and leaves his grandson $10,000,000. The entire $10,000,000 is subject to both estate and GST taxes. There is no exemption for the estate tax because the unified credit was used for the inter vivos gift.

Wrapping it up

So sorry for the lengthy, morbid post. But hey, these things matter. You work hard for your money, and you should keep as much of it as you can during your lifetime, and pass as much as possible onto your heirs (or some otherwise worthy individuals), as opposed to letting it slip into the blackhole of Federal and State taxes. Follow the advice above to set yourself up and your family members for this inevitable life event.

Wishing you nothing but happiness, health, and a life full of abundance!

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