Estate Taxation: An Ever-Changing Landscape
Estate taxes combine both of Benjamin Franklin’s often-quoted certainties: death and taxes. However, estate taxes are far from a certainty for most Americans. Federal estate taxes are levied on estates valued at more than $12.92 million per person in 2023, and that figure will rise in 2024 with the annual inflation adjustment. Most states do not even have an estate tax, and those that do have thresholds ranging from $1 million to $11 million. In 2020, only about 1,900 federal estate tax returns were taxable, which was less than 1% of all deaths that year. In fact, death triggers one of the most generous tax breaks in our tax code: the step-up in basis, which resets the cost basis of inherited assets to the market value on the date of death, which effectively wipes out any capital gains as of that date.
Why do we even have an estate tax? The IRS describes the estate tax as a tax on the right to transfer property at death. But shouldn’t people be able to leave their assets as they wish, without the state taking a share? Proponents of the estate tax argue that eliminating it would exacerbate wealth inequality and weaken our democracy. But haven’t taxes already been paid on the assets? While that’s partially true, a Treasury study in 2014 found that almost half of the fair market value of estates were unrealized capital gains that had not been taxed. It can be assumed that in estates large enough to be subject to estate taxes, that proportion would be even higher. Some opponents of the estate tax point out that it is complicated and so riddled with loopholes that the very wealthy can avoid much of the tax with the help of their attorneys.
Estate taxes are a revenue-raising measure for the governments that levy them, but the amount of revenue raised has been shrinking over the years as the threshold for applying them has been increased. The Congressional Budget Office reported that federal estate taxes contributed $16 billion in 2020 compared with $24 billion in 2001, which would be far higher if adjusted for asset inflation over the past 20 years.
History of the Estate Tax
Federal estate taxes were established in 1916, although they had been used in certain circumstances prior to that. A gift tax was added later to prevent avoidance of the estate tax through gifting during lifetime. In recent years, estate taxes have become a political football. Since the year 2000, we have seen the federal exemption rise from $675,000 per person to the current $12.92 million. In one year, 2010, the federal estate tax was totally eliminated, which enabled some families, such as the heirs of long-time New York Yankee owner George Steinbrenner, to reap a windfall, while surely mourning their loss. Soon politics will come into play again. In 2026, the current $12.92 million exemption, which will have risen to almost $14 million with the inflation adjustments, is set to revert back to approximately half that, because most provisions of the tax bill passed in 2017 will expire. There will undoubtedly be much discussion in Congress as expiration approaches, with some in favor of letting the exemption drop to lower levels and others pushing to retain the higher exemption or even eliminate the tax altogether.
One group that supports the continuation of the estate tax is the charitable community. Charitable contributions are deducted from the estate value prior to the tax calculation, thereby lowering the tax liability. Some people with estates large enough to face estate taxes may prefer to direct a portion of their estate to a charity than allow that portion to be subject to estate tax. Studies referenced by the Tax Policy Center have found that elimination of the estate tax could result in a 15-30% reduction in charitable bequests, which comprise about 8% of all charitable donations.
State Estate Taxes
Only 12 states plus the District of Columbia have an estate tax, in which the estate is taxed before the heirs receive their shares, and six states levy an inheritance tax, which applies to the heirs after they receive their bequests. The trend has been to lessen the impact of estate taxes over the years primarily by raising the thresholds for estate taxation. The Massachusetts legislature has just passed a tax reduction bill which will raise the estate tax exemption from $1 million to $2 million and will eliminate the “cliff” effect so that only assets in excess of $2 million will be taxed. In New York, the threshold for estate taxation is $6.58 million in 2023. In both states, there are progressive tax rate schedules with rates ranging from 3% to 16%.
Estate Planning
At the very least, anyone with substantial assets should meet with an estate planning attorney, who can provide advice on the best way to organize their holdings, whether their estates will be subject to either federal or state estate taxes. If there is a probability that estate taxes will apply, the attorney can help create a plan that will minimize the impact and ensure that the full exemption is utilized for both spouses. (In particular, Massachusetts taxpayers with estate plans based on the lower $1 million threshold should have their planning documents reviewed.)
For those with a projected estate value above $7 million ($14 million for a couple), time may be running out to take advantage of the currently high federal exemptions, assuming they will expire after 2025. Gifting as much as the full exemption before 2026 may be one way to do that. According to recently published IRS statistics, wealthy Americans gave away $182.6 billion in 2021, more than double the $75.2 billion in 2020. Almost $100 billion of those gifts were made via irrevocable trusts.
There are other, less extreme actions that can be used to lower the value of a potentially taxable estate, either at the federal or state level. One is to gradually give away assets during one’s lifetime, limiting the amount to no more than the annual maximum gift tax exclusion, which is $17,000 per person in 2023. That means a couple can gift up to $34,000 to each person and to as many people as they wish without triggering a gift tax. Lifetime gifts above the annual exclusion will be included in the taxable estate at death. Note that highly-appreciated assets may not be good candidates for gifting because the low cost basis transfers with the asset; better to allow them to be inherited at death when the cost basis can be stepped up to market value.
Roth conversions of Traditional IRAs provide a way to not only lower the value of a taxable estate through “prepayment” of income taxes upon conversion, but also help avoid the possibility of double taxation. That could occur if tax-deferred money is subject to estate tax and then is later taxed when the beneficiary withdraws the money, although the beneficiary may be able to recover at least a portion of the estate tax paid on their own tax returns. While Roth IRAs may be subject to estate tax, beneficiaries can withdraw from them tax-free.
As always, if you have questions around estate taxation or other topics, reach us at (833) 888-0534 x2 or by email.
The views and information contained in this article and on this website are those of West Branch Capital LLC and are provided for general information. The information herein should not serve as the sole determining factor for making legal, tax, or investment decisions. All information is obtained from sources believed to be reliable, but West Branch Capital LLC does not guarantee its reliability. West Branch Capital LLC is not an attorney, accountant or actuary and does not provide legal, tax, accounting or actuarial advice.
About The Author
Anne Christopulos
Anne is a Managing Director and Financial Planner with over twenty years of experience in the financial services industry. After holding corporate management positions in finance and strategic planning in New York City, she moved to Boston to become the Product Manager for the IRA business at Fidelity Investments. Following that, she was Vice President, Retirement Investments, at Fleet Financial Services. A native of Cape Cod, she returned to the Cape in 2001 and made the transition to personal financial planning with Secure Future Financial Services in Dennis and Davis Financial Services in Orleans before joining West Branch Capital. Anne holds a B.A. in music and economics from Wellesley College and an MBA from Harvard Business School.
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