Planning for Estate Taxes vs. Income Taxes

Traditionally, the federal estate tax was extremely burdensome to wealthier individuals, and the bulk of estate planning involved finding ways to minimize this federal tax.

However, the federal estate tax rates and exemption amounts have changed dramatically over the last two decades and become less of an overall burden. The 2019 federal estate and gift tax exemption is $11.4 million per person; compare that number to just $675,000 in 2000. The maximum federal tax rate in 2000 was 55%, and in 2018, only 40%.

On the other hand, other federal taxes have gone up. In addition, many states have also increased their income, estate, and inheritance taxes, leading to a larger pool of tax types to consider. As a result, smart estate planning now involves looking at all the different possible taxes that heirs might face and figuring out how best to reduce their overall tax burden.

Here's one example: Linda owns stock that she bought years ago for $30,000, and it's now worth $100,000. At some point, she wants the stock to go to her son, Adam, especially as she thinks it may continue to increase in value.

In the past, it might have made sense for Linda to give the stock to Adam immediately. That's because any further increase in the stock's value would belong to Adam, not Linda. When Linda passed away, her heirs wouldn't have to pay federal estate tax on the stock or the increase - and at a rate of 55%, that would have been a great burden.

However, it now might make more sense for Linda to leave the stock to Adam in her will. Since the federal estate tax rate is lower and the exemption amount is higher, Linda's estate might not have to pay estate tax as a result of keeping the stock.

In addition, if Adam received the stock as a gift and then sold it, he'd have to pay the capital gains tax on the $70,000 increase in value while it belonged to Linda - at today's higher capital gains rates. But if he inherited the stock and sold it, his capital gains tax basis would be increased to the stock's value as of the date Linda died, and he would avoid the tax.

Depending on the states where Linda and Adam live, there might be state estate taxes and/or state inheritance taxes, which may kick in at much lower thresholds, and there might also be state income and capital gains taxes to consider. The state and even local tax issues could further complicate the decision. In 2018, the Maryland estate tax exemption was set to $5 million for decedents who die on or after January 1, 2019. Prior to 1999, Maryland imposed a 1% tax on property passing to a child or other lineal descendant, spouse, parents, etc., and 10% on any other individual. After July 1, 2000, the state tax is now only 10% on property passing to an individual who isn't a "child or other lineal descendant, spouse of a child or other lineal descendant, spouse, parent, grandparent, stepchild or stepparent, siblings or a corporation having only certain of these persons as stockholders". All of those just listed are exempt from the tax.[1]

As you can see, it's still necessary to do careful tax planning if you wish to leave as much as possible to your heirs - it's just that the nature of that tax planning has changed. If you wrote your will years ago when the tax laws were quite different, you might want to review your estate plan now to see if it still makes sense under current conditions. As always, discuss any changes with your estate planning and tax professional before implementing any changes.

1https://taxes.marylandtaxes.gov/Individual_Taxes/Individual_Tax_Types/Estate_and_Inheritance_Tax/Tax_Information/Tax_Rates/