At this time of year, you can’t help but think about income taxes, but there are a few other taxes that you should know a little about.
The Estate Tax
The US tax system imposes an estate tax when a taxpayer dies. Every taxpayer has a credit against the estate tax that protects the first $5 million he or she owns. That credit amount is adjusted for inflation, and this year the total amount protected is $5,430,000. That means a married couple can protect nearly $11 million from the estate tax. For most people, the estate tax is no longer a real concern, especially when you consider the estate tax marital deduction, which says there’s usually no estate tax on assets that pass to a spouse. Even if you’re worth $50 million when you die, there will be no estate tax if you leave it all to your spouse. In 2012, only 9,400 taxpayers had estates large enough to trigger the estate tax, and about half of those estate passed tax-free to a surviving spouse. But the estates that paid paid big! The estate tax rates are graduated like the income tax rates, but once you break the $5 million mark, the applicable tax rate is 40%. The 9,400 folks who got it by the estate tax in 2012 paid over $8.5 billion in estate tax.
The Gift Tax
The estate tax applies when assets transfer as a result of a taxpayer’s death. So why don’t you just give all your assets away before you die to avoid the estate tax? That’s the role of the gift tax. It applies to transfers made during life. These two taxes are intertwined because a taxpayer’s credit for the estate tax can be applied to the gift tax. I can give $5,430,000 away during my life or I can give $5,430,000 away at my death; but I can’t give more than $5,430,000 without paying one of these taxes. If I decide to use some of my credit to make big gifts while I’m alive, then I’m required to disclose the transfer by filing a gift tax return (IRS Form 709).
In 2013, the IRS received about 370,000 gift tax returns showing total transfers of more than $420 BILLION. You’ve already figured out that the top gift tax rate is the same as the top estate tax rate (40%), so you’re expecting to hear that the IRS received more than $150 billion in gift tax. It didn’t. It only received about $4.6 billion in gift tax. How can that be? Smart taxpayers take full advantage of another gift tax – the $14,000 annual exclusion. In addition to the $5,430,000 credit, every taxpayer can give an unlimited number of people $14,000 tax-free every year. This is a powerful strategy. Every year, my mother-in-law could give $14,000 to each of her six kids, their spouses and her twelve grandkids, transferring $336,000 tax-free to her family members. Her husband could do the same thing, bringing their total tax-free gifts to $672,000 per year. If they did that for 15 years, they would transfer more than $10 million free of gift tax. Smart taxpayers use the annual exclusion to transfer literally billions of dollars of assets tax-free.
The Capital Gain Tax
For a long time, the gift and estate tax rates were significantly higher than capital gain tax rates. (Capital gain is a tax on the appreciation or growth of an asset you own.) When I started practicing law, the credit against the gift and estate taxes was limited to $600,000, and the top gift and estate tax rate was 55%. At that time, the federal capital gain tax rate had just dropped from 28% to 20%. Whenever a client had to pick between paying one of these three taxes, the choice was easy – you did all you could to avoid the gift and estate taxes. These days, it’s not so clear. The top gift and estate tax rate is down to 40%. (It’s important to remember that some states impose their own estate or inheritance tax. Visit this site to see if you live in such a state: http://taxfoundation.org/blog/state-estate-and-inheritance-taxes-2014.)
I live in California, and if you add up the state and federal capital gain taxes, the total rate reaches 37.1%. Why does this matter? Let’s suppose I bought stock in a tech company 10 years ago for $8 a share. If it’s worth $208 today and I sell it, then I have $200 in taxable capital gain per share. If I give $14,000 of the stock to my son, the rules say he takes my income tax basis. If he sells the stock, he’ll have the same taxable capital gain I would have. Different rules apply if he inherits the stock from me. If he gets my shares as a result of my death, his income tax basis will be the fair market value on the date of my death. Suddenly, inheriting assets makes more sense, especially since the rules allow me to pass a very significant amount of assets estate tax free.
The income tax will stay in focus between now and April 15th, but now you have a better understanding of the other taxes that deserve consideration in your financial planning.