When preparing or updating your estate plan, you will need to have a basic understanding of the different types of taxes that can affect your estate - gift taxes, estate taxes, inheritance taxes, generation skipping (or GST) taxes, and income taxes.
Gift Taxes
The gift tax is probably the most ignored tax that can affect an estate. Currently the federal tax code exempts up to $13,000 per year in gifts made by any individual to any number of other individuals - this is referred to as the annual exclusion from gift taxes. Once you make a gift over $13,000 in any given year to the same person, you'll be making a taxable gift and you'll incur a gift tax. However, instead of paying the tax immediately, the federal tax code gives you a lifetime gift tax exemption of $1,000,000 that can be used to offset your taxable gifts. Think of the gift tax exemption as a "$1,000,000 coupon" against the application of the gift tax.
For example, let's assume that this year you decide to gift $113,000 to your son for a down payment on a house. For gift tax purposes, the first $13,000 will have no consequence, but the next $100,000 will be considered a taxable gift. Thus, once the gift is made, instead of having a $1,000,000 gift tax coupon, you'll only have a $900,000 coupon.
Taxable gifts made during the course of the year need to be reported on IRS Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, which must be filed on April 15 of the year following the year in which the gift was made.
Two states still currently impose their own gift tax in addition to the federal gift tax: Connecticut and Tennessee. Louisiana abolished its gift tax as of July 1, 2008, and North Carolina abolished its gift tax as of January 1, 2009.
Estate Taxes - Federal and State
Currently the federal estate tax applies to estates that are valued at more than $3,500,000, which is referred to as the federal estate tax exemption. In 2010, current law provides that the estate tax will go away for that year, and then in 2011 the exemption is scheduled to decrease to $1,000,000. Where the estate tax will go in the next several years will depend on what Congress and President Obama decide to do with it.
Note that the $1,000,000 federal gift tax coupon discussed above is tied to the $3,500,000 federal estate tax exemption. In other words, if use some of your $1,000,000 gift tax coupon during your lifetime, then after you die your estate tax exemption will be reduced by the amount of your lifetime gifts. For example, if you use $500,000 of your gift tax coupon while you are alive, then you will only have $3,000,000 of your estate tax exemption left when you die.
As of 2009, 18 states and the District of Columbia impose a separate state estate tax: Connecticut, Delaware, Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, North Carolina, Ohio, Oklahoma, Oregon, Rhode Island, Tennessee, Vermont, and Washington.
State Inheritance Taxes
As of 2009, there are also a few states that collect a separate inheritance tax, which is a state tax imposed upon certain beneficiaries who receive a deceased person's property: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. In all of these states assets passing to the deceased person's surviving spouse and charity are exempt from the inheritance tax, while in several of these states - Iowa, Kentucky, Maryland and New Jersey - assets passing to the deceased person's descendants are also exempt. Note that currently Maryland and New Jersey are the only two states that assess both estate and inheritance taxes.
State laws frequently change, however, so it is best to consult with a qualified estate planning attorney in your state to determine if your assets will be subject to a state estate tax or inheritance tax at the time of your death. Also, if you own personal effects or real estate outside of your home state and the other state has an estate tax or inheritance tax, then there may be an estate tax or inheritance tax due on your out of state property after your death.
Generation Skipping Taxes
Currently the federal generation skipping transfer tax, or GST tax, applies to transfers of more than $3,500,000 that “skip” one or more generations. “Skip” refers to either a transfer that is made to a relative who is two or more generations below your generation (for example, a grandparent to a grandchild), or to a non-relative who is more than 37 ½ years younger than you. This $3,500,000 limit follows the estate tax – in other words, the changes in the federal estate tax described above are also scheduled to occur to the generation skipping tax.
The majority of the states that still impose their own separate state estate tax also assess a separate generation skipping tax. However, as with state estate taxes and inheritance taxes, it is best to consult with a qualified estate planning attorney in your home state to determine if your state has its own generation skipping tax.
Income Taxes
During the course of settling an estate or trust after someone dies, the estate or trust assets will undoubtedly earn interest until they can be distributed out of the estate or trust to the ultimate beneficiaries. Aside from this, certain types of accounts have built in income tax consequences when the owner dies, such as non-Roth IRAs, 401(k)s, and annuities. Thus, while many estates and trusts may not be affected at all by gift, estate, inheritance, or generation skipping taxes, the majority will be affected in some way or another by income taxes.
