Estate tax planning: Tips to help you pass on your wealth

Like many Americans, you may be planning to pass on some of your wealth to your loved ones. Such gifts can be a wonderful embodiment of your love and can help your heirs achieve a new level of financial security.

However, there's more to estate management than simply swapping the names on your bank accounts. Your estate could owe taxes on property that transfers when you die, which would reduce the total value of the assets available to your beneficiaries.

The good news is that you can minimize the impact of these "death taxes" through thoughtful estate tax planning. The first step is understanding the nuances of how taxes fit into wealth transfer strategies to use them to your advantage, whether upon your death or during your lifetime.

Here's what you should know to help you strategize your estate tax planning.

Your estate will consist of all your money and all the property you own or co-own at the time of your death. It could include your cash, securities, home, insurance, works of art and business interests.

You can use certain deductions to shrink the size of your taxable estate. These include:

• Funeral expenses paid out of the estate
• Debts owed at the time of death, including mortgages
• The marital deduction, which is generally the value of the property that passes to the surviving spouse
• The state death tax deduction (A minority of U.S. states levy their own estate taxes, and the threshold to trigger these taxes may be lower than the federal threshold.)
• The charitable deduction, which generally includes the value of the property that goes from the estate to a qualifying charity (This is one of many ways that charitable giving can help reduce your estate tax.)

The value of your taxable estate will determine if you pay estate tax. Note that word: "if." Unlike death, estate tax isn't inevitable. In fact, most estates don't pay estate tax.

Here's why: The federal estate tax only applies to estates that are worth more than an inflation-adjusted amount. That estate tax exemption, which is also called the basic exclusion amount, is currently very high:

• 2023: $12.92 million
• 2024: $13.61 million

The threshold is doubled for married couples ($25.84 million in 2023 or $27.22 million in 2024) since, with the appropriate paperwork, an unused exemption of a deceased spouse can be transferred to a surviving spouse.

Estates that do need to pay federal estate taxes face a steep bill: The portion of an estate's value that exceeds the exemption is subject to a top rate of 40%.

While only the estates of the very wealthy may need to pay estate tax, more estates could be on the hook for the tax in the future. That's because the exemption could drop to $5 million with the sunset of the Tax Cuts and Jobs Act in 2025.

Giving away assets during your lifetime is another way to reduce the size of your taxable estate. This strategy has financial benefits and also can be extremely rewarding. You can witness the joy of recipients and see how your money helps them pursue dreams like advancing their education, buying a house or starting a business.

Transfers of wealth that you make while you are alive could be subject to gift tax from some states and at the federal level. However, the federal gift tax has many exceptions.

Gifts that are generally tax-free include:

• Gifts to a spouse who is a U.S. citizen
• Tuition or medical expenses paid directly to a school or medical provider on someone's behalf
• Gifts to a political organization
• Gifts to qualifying charities

In addition, you can take advantage of a federal gift tax exclusion each year that applies to individual gifts. The annual exclusion amounts per donee are:

• 2023: $17,000
• 2024: $18,000
  

Let's say you have five children; you could give each of them up to $17,000 in 2023 without worrying about the gift tax. In addition, if you're married, you and your spouse can combine your exclusions, meaning that you two together could give $34,000 to an individual recipient in 2023.

What happens if you gift someone something that exceeds the annual limit? You'll need to fill out a gift tax return, but you won't necessarily owe taxes.

The reason for this goes back to the basic exclusion, which also pertains to lifetime gift taxes and is like a credit you can use to avoid paying the gift tax. Any gifts that are above the annual giving limit will essentially reduce your basic exclusion by their excess amount. On the other hand, your basic exclusion won't decrease at all if you stay under the annual gift limit for each recipient.

The basic exclusion is linked to one more type of transfer: the generation-skipping transfer (GST). It pertains to assets you give to someone two or more generations below you, such as your grandchildren, during your lifetime or after you die.

This kind of transfer also can help you reduce your taxable estate, but the rules around its taxation are particularly complicated. It's a good idea to seek professional accounting help to devise a smart strategy for GSTs.

Some assets trigger capital gains taxes when you sell them for more than the price you paid, which is called the cost basis. These can include stocks, bonds, mutual funds and real estate.

Gifting these kinds of assets that have appreciated in value to loved ones or to charities while you are alive could potentially enable you to bypass capital gains taxes while reducing your taxable estate. Alternatively, if you wait to pass on those assets upon your death, your heirs could receive a capital gains benefit if the assets aren't held in a tax-deferred vehicle like an individual retirement account. It should, however, be noted that gifts given during the owner's lifetime take original owner's tax basis which could result in a higher tax liability than gifts given at time of death.

Thanks to what's known as a step-up in basis, the inherited asset's unrealized capital gains will effectively vanish because the cost basis generally resets to the asset's value upon the date of death. Only subsequent price appreciation could result in a capital gain, which in turn could reduce capital gains taxes.

One downside to this approach is that the assets would be included in your taxable estate, which could get tricky if your estate's value is nearing the basic exclusion amount.

Another estate tax planning strategy to consider is permanently moving some assets out of your ownership—and control—by placing them in irrevocable trusts.

Not only will the assets in your trust live outside of your estate, but they also can help you accomplish other goals. These include funding legacies for children or grandchildren, making gifts of property or life insurance and supporting causes that are important to you.

Transferring assets to loved ones and structuring charitable gifts in beneficial and tax-friendly ways require an exhaustive knowledge of the tax code as well as top-notch legal and financial expertise.

In addition to working with an estate planning attorney and tax professional, connect with a financial advisor for a personalized look at your unique situation and guidance around how your assets can make the biggest impact possible both before and after your passing.