Understanding Estate and Income Taxes in Estate Planning for 2024
When planning an estate, one of the most important aspects to consider is how taxes will affect the distribution of assets. In 2024, estate taxes apply only to very large estates, meaning that most people will not be subject to estate taxes. However, understanding how estate taxes, income taxes, and other tax obligations impact an estate can help ensure that beneficiaries receive their intended gifts with minimal complications. In this post, we’ll discuss the current estate tax exemption, the difference between estate taxes and income taxes, and options for managing taxes within an estate plan.
2024 Estate Tax Exemption: What You Need to Know
As of 2024, individuals can pass on up to $13.6 million in assets tax-free. This means that only estates valued above this threshold are subject to federal estate taxes. For married couples, this exemption effectively doubles to $27.2 million, assuming they take advantage of both spouses’ exemptions.
- Exemption Threshold: The estate tax exemption in 2024 is $13.6 million for individuals. Estates under this threshold are not subject to federal estate taxes.
- Unlimited Spousal Transfers: Additionally, there is no limit to the amount that can be transferred to a surviving spouse free of estate tax. This provision, known as the marital deduction, allows a surviving spouse to inherit the entirety of an estate without triggering estate tax, regardless of the estate’s size.
Because of this high exemption amount, the majority of estates in the United States will not owe federal estate taxes. This exemption amount, however, is subject to change annually and may decrease significantly in future years, depending on tax laws. Therefore, those with estates approaching this threshold may benefit from consulting an estate planning attorney to stay informed of potential changes.
Estate Tax vs. Income Tax: Understanding the Difference
A common point of confusion in estate planning is the difference between estate taxes and income taxes. Here’s a breakdown of each:
- Estate Taxes: Estate taxes are taxes imposed on the total value of a person’s estate upon their death, before assets are distributed to beneficiaries. As mentioned, only estates valued over $13.6 million in 2024 are subject to federal estate taxes. The estate itself is responsible for paying any estate taxes owed, typically from the estate’s assets, before distributions are made to beneficiaries.
- Income Taxes: Income taxes apply to any income earned by the deceased during the year of their death. If the decedent received income (such as wages, dividends, or other earnings) in the year of their passing, a final income tax return must be filed on their behalf. This income tax return functions similarly to any individual income tax return, covering the period from January 1 to the date of death. The income tax liability is separate from the estate tax and must be paid by the estate before distributing the remaining assets.
How Estate Planning Can Address Tax Obligations
When creating an estate plan, individuals have a range of options for managing taxes on their assets. Here are some common strategies and considerations:
- Determining Who Will Pay the Taxes: One important aspect of estate planning is deciding who will be responsible for paying any taxes that may arise. The individual creating the estate plan can specify their preferences in their will or trust. For example:
- Gift Taxes Paid by the Estate: The estate can be directed to cover any taxes on gifts so that beneficiaries receive their inheritance tax-free.
- Pro-Rated Share for Beneficiaries: Alternatively, the estate plan may specify that each beneficiary is responsible for paying a proportionate share of taxes, based on the size of their inheritance. This arrangement ensures that taxes are equitably shared among beneficiaries.
By outlining these instructions in a will or trust, the estate owner can help reduce the risk of disputes and ensure a fair division of tax responsibilities.
- Using Life Insurance to Cover Taxes: Some individuals choose to take out a life insurance policy with the intent of covering any potential estate tax liabilities. In this scenario, the estate is named as the beneficiary of the policy, and the proceeds from the life insurance are used to pay estate taxes. This strategy can help protect the estate’s other assets, allowing them to pass to beneficiaries without the need to liquidate valuable property to cover taxes.
- Gifting Strategies to Reduce Estate Value: For individuals with substantial estates, gifting assets during their lifetime can help reduce the estate’s taxable value. The IRS allows for annual gifts up to a certain limit (currently $17,000 per recipient in 2024) without triggering gift taxes. By gifting assets to beneficiaries over time, individuals can reduce the value of their estate, potentially avoiding estate taxes.
- Establishing Trusts for Tax Efficiency: Trusts are another tool commonly used in estate planning to manage taxes. Trusts allow assets to be transferred outside of the probate process, and certain types of trusts, such as irrevocable life insurance trusts (ILITs) and charitable remainder trusts, can also provide tax benefits.
- Irrevocable Life Insurance Trust (ILIT): An ILIT is a trust that holds a life insurance policy outside the taxable estate, helping reduce estate tax liability.
- Charitable Remainder Trust (CRT): A CRT allows individuals to donate assets to charity, reducing the taxable estate value while providing beneficiaries with income from the trust during their lifetime.
Addressing Tax Obligations When No Estate Plan Exists
In cases where a person dies without an estate plan, California’s probate code dictates how taxes are handled. If there is no will or trust specifying who is responsible for taxes, the court will apply default rules outlined in state law. This may involve:
- Determining Tax Liability: The probate court will establish which assets are subject to tax and calculate the total tax due.
- Paying Taxes from Estate Assets: The estate will typically use available assets to pay off any outstanding taxes before distributing remaining assets to beneficiaries.
Without a clear estate plan in place, the tax process can become more complex and time-consuming. To avoid this situation, it is advisable to consult an estate planning attorney to establish a clear plan for tax responsibilities.
Key Considerations for Estate Planning in 2024
Here are some important questions and considerations to keep in mind when planning for taxes in an estate:
How Much Is the Estate Worth?
Calculate the total value of assets to determine whether estate taxes are likely to apply. Remember that the exemption amount for 2024 is $13.6 million, but this figure changes periodically, so future planning should take potential decreases in the exemption amount into account.
What Type of Taxes Will Apply?
Consider both estate taxes (for very large estates) and income taxes (for the year of the decedent’s death). Understanding the type of tax liability that will apply can help avoid confusion and ensure taxes are handled correctly.
Who Will Be Responsible for Paying Taxes?
Specify in your will or trust who should be responsible for paying any taxes due. Clearly outlining these responsibilities can help prevent misunderstandings among beneficiaries and make the estate administration process smoother.
Are There Specific Assets to Designate for Paying Taxes?
In some cases, it may be beneficial to set aside certain assets for covering tax liabilities, such as a life insurance policy or specific cash reserves. This ensures that beneficiaries receive their intended gifts without the burden of an unexpected tax bill.
Navigating estate and income taxes in estate planning can seem complex, but with careful planning and guidance, you can create a strategy that minimizes tax liability and ensures a smooth transfer of assets. In 2024, the high estate tax exemption will shield most estates from federal estate taxes, but considerations around income taxes and tax liability for beneficiaries are still important factors.
If you’re unsure about how to manage taxes within your estate plan, consulting with an experienced estate planning attorney can help you make informed decisions that protect your assets and ensure that your wishes are carried out.