The population is growing and lifespans are increasing. Increasing numbers of people are reaching an age where estate planning and transferring their property, savings, and assets to others are demanding serious strategic thinking. Goldman Sachs Asset Management has noted that “a demographic and massive wealth transfer story is underway as the Silent Generation (those in their seventies and above) pass on their wealth to Baby Boomers and Generation X.”
But how do you do that tax-efficiently? You have numerous options and exploring them can preserve more of that wealth for your family, avoiding the bite that taxes will take if you don’t proceed with caution and care.
- Federal law provides an estate tax lifetime exemption that allows an individual to transfer up to $13.61 million tax-free to beneficiaries in 2024. It also allows one spouse to pass their wealth to the other spouse, tax-free and with no limit.
- The tax code also provides an annual gift tax exclusion of $17,000 per person per year in 2023 ($18,000 in 2024).
- Strategies to transfer wealth without a heavy tax burden include creating an irrevocable trust, engaging in annual gifting, forming a family limited partnership, or forming a generation-skipping transfer trust.
The Fundamentals of Wealth Transfer
The purpose of an estate plan is to ensure that your property and money goes to the individual or individuals of your choice while minimizing the impact of estate and gift taxation. Whatever the value of your estate, having a plan for its disbursement will help your heirs access their inheritance more quickly and smoothly.
Federal law provides an estate tax lifetime exemption that allows an individual to transfer up to $13.61 million tax-free to beneficiaries in 2024. The exemption is indexed for inflation so it tends to increase annually, but it’s expected to plunge at the end of 2025 when the Tax Cuts and Jobs Act (TCJA) expires unless the law or this particular provision is extended.
Anything you pass on to others that’s valued at more than the exemption amount can be taxed at a rate of as much as 40% in 2023. This 40% rate has been in place since 2013.
The estate tax applies to everything you own at the time of your death, including partial interests in some assets, but not to the overall value of your assets, referred to as your “gross estate.” Your heirs are permitted to subtract mortgages, the costs of administering your estate, any gifts you give to charity, other debts you hold at the time you die, and anything you leave to your spouse.
The Tax Cuts and Jobs Act nearly doubled the estate tax lifetime exemption when the law was passed in December 2017. The exemption could be cut to as little as $7 million when the TCJA expires in 2026.
The Unlimited Marital Deduction
Federal tax law allows you to pass your wealth to your spouse with no limit. These transfers are completely tax-free whether they occur during your lifetime or when you die. Of course, this only postpones the tax bite. The second spouse to die will presumably leave the assets and property to others and its value may well grow in the interim to exceed the available estate tax exemption.
The Portability Rule
The Internal Revenue Code (IRC) has a rule that’s been in place since January 2011 that allows spouses to mitigate the bite of the estate tax. The first spouse to die can transfer any unused portion of their own lifetime exemption to the survivor.
Let’s say they have used only half of the $13.61 million lifetime exemption. The surviving spouse can add the remaining $6.8 million to their own $13.61 million exemption for a total of $20.42 million under this portability rule. The surviving spouse must file an estate tax return for the decedent to claim this right. It’s worth noting that only Hawaii and Maryland offer portability for state-level estate taxes.
Ideally, both spouses are U.S. citizens because some restrictions apply otherwise. The IRS includes same-sex spouses provided that they’re legally married, but it doesn’t recognize registered domestic partnerships or civil unions.
Tax-Efficient Ways to Transfer Wealth
Federal law provides a few other strategies to transfer your wealth without an undue tax burden if you’re not married or if you want to leave a portion of your estate to others.
Form an Irrevocable Trust
A trust is a legal entity set up by a grantor who is typically the original owner of the assets it holds. The grantor then funds the trust by transferring ownership of their property into its name or into the name of a trustee—the individual or entity designated to run and/or settle the trust upon the grantor’s death.
Forming an irrevocable trust can be especially helpful because you can design it in such a way as to hold your life insurance policy so its value doesn’t contribute to the value of your taxable estate at the time of your death. The assets the trust holds don’t contribute to the grantor’s taxable estate.
Any income earned by the assets held within the trust are taxed to the trust, not to the grantor, because the trust technically now owns the income-producing assets. This provides a benefit during your lifetime as well, easing your annual income tax burden.
The downside to an irrevocable trust is that, as the name suggests, it can’t be amended, changed, or revoked by the grantor. It’s forever. The grantor can’t reclaim the property they’ve placed into it. This is not the case with a “grantor” or revocable trust, which allows the grantor or creator to take back and reclaim assets placed into it or even to dissolve the trust completely. They can delete beneficiaries or add new ones without restriction.
Engage in Annual Gifting
It might seem far less complicated to simply give your wealth away during your lifetime, but the IRS has rules in place for this, too.
The gift tax works in tandem with the estate tax, but it’s actually a separate levy. Gifting during your lifetime can ultimately decrease the value of your eventual estate because you’ve already given much of your wealth away, rendering your estate nontaxable. The IRS doesn’t want that to happen so it imposes both taxes.
But the tax code provides an annual gift tax exclusion of $18,000 per person per year as of 2023. You can give this much away, free of taxation, and the amount is adjusted annually for inflation. Plus, that $18,000 is more generous than it might appear at first glance.
“Take advantage of the gift-splitting provision,” advises Mike K. Earl, a certified financial planner and partner and director of The Wealth Group, Austin B. Colby & Associates in Minnesota. “For example, a married couple could give $36,000 to their son ($18,000 as a gift from each spouse). If this same couple’s son was married with two children, the couple could give up to $144,000 each year to their son’s family.” (Each spouse can give $72,000.)
You’re also granted a lifetime gift tax exemption but it’s unfortunately shared with the estate tax. Gifts that exceed the $18,000 yearly exclusion can be applied to your lifetime exemption so the tax isn’t payable until your death, and they would then only be taxed if the total value of your estate and your lifetime gifts exceeds $13.61 million.
As with the estate tax, gifts made to your spouse or to a charity don’t count against these limits. But lifetime gifts can subtract from the lifetime exemption if you do this, leaving less dollar-value protection for your estate.
The annual gift tax exclusion is also indexed for inflation.
Explore Other Gifting Options
Gifts made directly to a qualified educational institution or to a healthcare provider on behalf of someone other than yourself can be made tax-free. Tuition and medical bills don’t apply against the annual gift tax exclusion, nor do gifts made to political organizations.
Form a Family Limited Partnership
A family limited partnership (FLP) provides joint ownership of family-owned assets to family members. Family members are either general partners or limited partners who assume varying (or no) responsibility for controlling the assets placed into the FLP’s ownership and managing its investments.
Parents and grandparents who donate their wealth and assets into an FLP then serve as partners who can transfer their own partnership interests to other family members, including their children and grandchildren.
This can minimize or entirely dodge gift and estate taxes and protect assets from personal creditors, but the IRS does require that the partnership have a clear and definable business or investment purpose. It must be created in such a way as to earn income of its own, and family partners must report that income on their own tax returns for income tax purposes.
“These structures can centralize family wealth management, provide some asset protection, and offer opportunities for tax-advantaged gifting through the use of valuation discounts,” says Celeste Robertson, a Texas-based estate planning and probate attorney with offices in Rockport and Corpus Christi.
Form a Generation-Skipping Transfer Trust
The generation-skipping transfer (GST) tax targets both lifetime gifts and estate bequests made to anyone who is at least 37½ years younger than you, such as grandchildren or great-grandchildren you want to include in your estate plan.
The tax code provides for a generation-skipping transfer tax lifetime exemption as well, and it’s also currently valued at $13.61 million, but again, this is shared with the combined gift and estate tax lifetime exemption. Its current annual exclusion is also $18,000. This tax is also levied at 40%.
But you have an option here as well. “Employing a generation-skipping trust can allocate the GST tax exemption effectively and help in preserving wealth across generations,” Robertson told us.
The “skip person”—the individual who is two or more generations younger than the giftor, the individual making the gift—must be the sole beneficiary of the trust and must have withdrawal rights to take advantage of the annual exclusion.
What Is the Most Tax-Efficient Way to Transfer Wealth?
There isn’t just one way to transfer wealth that is the most tax efficient. Rather, the best strategy depends on each individual’s situation and may rely on a combination of strategies. Meeting with an estate tax lawyer or financial planner can help you determine the best way to pass on your wealth to your heirs.
What Are Some Strategies for Transferring Wealth?
One strategy is to give away some or all of your wealth over your lifetime rather than transfer it after your death. The tax code provides an annual gift tax exclusion of $17,000 per person per year in 2023 (the amount rises to $18,000 in 2024). Or you can create a generation-skipping transfer trust to provide for anyone who is at least 37½ years younger than you, such as grandchildren or great-grandchildren you want to include in your estate plan.
What is “the Greatest Wealth Transfer”?
The greatest wealth transfer is an intergenerational transfer of wealth that is happening in the United States right now. Baby boomers, who are beginning to die off now in larger numbers, are projected to leave their heirs, millennials and Gen Xers, $84 trillion through 2045. The U.S. tax code plays a part in the size of the transfer since individuals can give their heirs $13.61 million during their lifetimes or after death free of federal estate taxes.
The Bottom Line
The federal gift and estate tax structure is generous enough to allow many, many individuals to pass their wealth and assets to their loved ones tax-free, at least through 2025 when the $13.61 million lifetime exemption potentially expires.
But that’s not to say that you don’t want to know and understand all your options so you can properly plan for the future. Keep these taxes and options in mind as you plan your estate and consider touching base with an attorney or tax professional who can guide you and keep you up to date with any changes in the law.