Death and Taxes
This article will attempt to address one the most common questions surrounding estate planning - taxes. In it, we will look at the four most common taxes that may (or may not) be of concern for your estate. 1) Estate Tax 2) Gift Tax 3) Capital Gains Tax and 4) Income Tax.
Starting with the big one, Estate Tax, also known as the death tax or inheritance tax, is the most commonly asked about, while simultaneously being the least commonly applicable tax for most families. Estate Tax, when applied, is paid only at death and is calculated by looking at the value of the wealth being passed on from the deceased individual. If the value of your estate upon death is larger than the applicable limits, then your estate will pay on this tax prior to any beneficiaries receiving assets. For most individuals, the value of your estate will fall under the Federal and State limits, thereby avoiding this tax altogether.
In the State of Maine, the Estate Tax exemption is $6.8 million, for 2024. This means that the only time you pay Estate Tax is if your taxable estate is at least $6.81 million or more. For every dollar over that limit, your estate will pay a tax, ranging from 8% to 12%, depending on how far beyond the limit your wealth reaches. The State of Maine Revenue Services provides a handy chart to calculate that tax value. You must file Maine form 706ME if your taxable estate is beyond this limit.
Federally, the Estate Tax exemption is $13.61 million, for 2024. The amount of tax paid ranges greatly, again, depending on how far beyond the limit your taxable estate reaches. The tax rate for federal estate tax ranges between 18% to upwards of 40%, once you’ve reached one million dollars beyond the limit. You must file IRS form 1041 if your taxable estate is beyond this limit. When calculating this tax, you can expect to pay both State and Federal numbers, meaning on the upper end, you could be facing a 52% tax for every dollar over the limit. For married couples, each spouse gets to take advantage of these limits, thereby doubling the limits, regardless of who actually owns the wealth. These limits are subject to change, and we expect them to be lowered in 2026. If your estate exceeds, or is approaching these limits, schedule a time to meet with your attorney to discuss strategies to mitigate this tax.
The next tax is closely related to the Estate Tax and that is Gift Tax. Gift tax is tied directly to estate tax, in that it shares some of the same limits. It is also important to remember that the State of Maine does not have Gift Tax, so this is strictly a federal tax for Maine residents. This is not the case for every state, so always check your local laws.
Gift tax is broken down into thresholds, first: at what point do I need to report my gift to the IRS? and second: at what point do I need pay tax on my gift? Every year, individuals may make as many gifts, to as many other individuals as they like, and so long as that gift is under the annual exclusion then nobody needs to know about the gift. There is no requirement to report the gift to the IRS. The annual exclusion is $18,000 for 2024. That number has been trending the last few years and increasing by exactly $1,000 each year, and we can expect it to continue along that pattern. If, however, an individual makes a gift of say, $20,000, then they must file IRS form 709 to report that gift. At this time, you still are not required to pay gift tax. That gift, however, is going to count against your lifetime total. That means, you will have a slightly smaller threshold for estate taxes. Any gifts made during your lifetime in excess of the annual limits will count against your federal estate tax limit. That means, you will only pay gift tax during your lifetime if you give gifts in excess of $13.61 million, otherwise, it will contribute towards your estate limit.
The next tax is more common, but still avoided in most scenarios and that is Capital Gains Tax. Capital Gains Tax, or CGT, as we’ll call it, is the tax you pay on the sale of an asset, based on it’s appreciation during your ownership. Most commonly, this tax is paid on stocks and real estate, but can also be applied to business appreciation. CGT is paid only when an asset is sold. An easy example is real estate, if you purchased your house in 1990 for $100k (this is known as your basis), then sell it in 2024 for $350k, then you pay a tax on that gain, the $250k that your house appreciated in value. The amount paid in tax ranges, depending on some factors. CGT falls into two categories, short-term gains, and long-term gains. If you held that asset for one year, or less, then it’s considered a short-term gain. If you hold an asset for more than one year, then it’s considered a long-term gain. Long-term gains are taxed more favorably, between 0% - 20%, depending on how much that asset appreciated. Short-term gains face a steeper tax, and are taxed as ordinary income, thereby facing taxes between 10% to upwards of 37%, depending on your highest tax bracket for the year in which you sell. Because short-term gains count as income, this can affect your income tax for the entire year as well.
There are many rules when considering CGT, but the most applicable for estate planning are exemptions for your primary residence, and step-up rules. When you sell your primary residence and you are calculating how much CGT to pay, you exclude the first $250k of gains - that money is not taxable so long as you have lived in your home for at least two of the last five years. This means that for most people, when they sell their primary residence, there will be no CGT owed. This exemption is only for your primary residence, so second-homes, rentals, investment properties, camps, and the like will still face the full tax bill. There are strategies for mitigating this tax or even avoiding it all-together, which should be discussed in detail with your attorney.
The second major rule to consider is what is known as step-up in basis. Your basis is the value which you originally acquired the asset. In our example above, the home purchased at $100k means $100k is our basis. To calculate CGT, we subtract the basis from the sale value ($350k) and the result is the amount that is taxable. Basis is very important, generally speaking, a higher basis means less taxes owed. This is where the planning comes, because it is easy to accidentally transfer your (very low) basis to an unsuspecting beneficiary. It is very common to add a beneficiary, usually a child, as a joint owner to financial accounts and real estate. By doing so, you are also transferring your basis, meaning as the asset appreciates in value over your lifetime, and your beneficiary’s lifetime, the tax is also increasing. If the beneficiary goes to sell the property long after your death, they still need to use your original $100k basis, in this example. However, if we allow our beneficiaries to inherit the property only at death, rather than be added during our lives, they receive what is known as a step-up in basis. They get to use your date-of-death value as their new basis, meaning if they sell it shortly following your passing, they will likely face no tax consequences. Often times, trusts can be utilized for this purpose, which is a conversation you should have with your attorney.
The final tax to consider is Income Tax and here, we are only talking about the income tax that your beneficiaries pay on your wealth, not the income tax that you pay during life. Most assets inherited by beneficiaries are considered by the IRS to be “already taxed for income”. Beneficiaries are not going to pay income tax on inherited money, except in the case of qualified retirement accounts. These are things like 401(k)s, IRAs, 403(b)s, and 457 plans. The money that goes in to those accounts typically goes in before income tax is paid, meaning those accounts get to grow during your lifetime without having ever been taxed for income. When the money comes out of those accounts, the income tax is owed. The income tax is calculated based on a few factors, the recipient’s tax bracket, the current tax limits, and who the recipient is.
Obviously, if you withdraw this money during your lifetime, then it counts as income, and you need to pay tax on it. Many of these accounts have required minimum distributions at certain ages in which you must withdraw some amount each year, and pay tax on it, but otherwise, you can take distributions slowly for the rest of your life, and often there is money left over to pass along. When money is passed along, now it is the beneficiary who must count that money as ordinary income. This means that the inherited account gets tax according to the beneficiary’s tax bracket. If that beneficiary is still working, they may be in a higher tax bracket than you were in retirement.
The next consideration is the income tax brackets themselves. Currently, the tax ranges from 10% to 37%, depending on how much income you earn in a single year. Those values change, depending on how you file your taxes (single, married, jointly, etc.) The concern, of course, is the unknown - what will those numbers look like for our beneficiaries? Will they have the same brackets? Will the brackets keep up with inflation? Are those brackets going to shrink? The problem - we don’t know. The fear is that the amount taxed in 20 to 30 years will be higher than the amount taxed now. And while you should not plan based on fear, it is okay to think critically about your tax planning.
The last consideration comes from the SECURE Act. In 2019 the SECURE Act was passed to capture more of these retirement accounts, which were previously being passed from generation to generation without much tax being paid. The SECURE Act limits the amount of time that most beneficiaries have to withdraw assets from retirement accounts. Spouses who inherit a retirement account can take that account, roll it into their own name, and take distributions out slowly, based on their life expectancy. Beneficiaries who are disabled children, within 10 years of age of the decedent (like siblings, usually), or minor children (so long as they are still underage), can also use their life expectancy. Anyone else who inherits this account only has 10 years to withdraw the funds entirely, and pay the tax. This means that their timeline to pay the income tax has been accelerated. This will likely result in a higher income tax bill for those beneficiaries.
All of these taxes are important to consider when you are setting up your estate plan. You should always speak with your attorney about each of these, and have an attorney on your team who is keeping up-to-date on these limits, as they change annually. If you feel that your estate plan is not addressing all of these concerns, then set up an appointment with an attorney from Rune Law to have that conversation surrounding your tax planning.
