Understanding Federal Income and Estate Taxes: A Simple Guide to Saving Money

If you're someone who is looking to save money on your taxes, you've come to the right place. Taxes can seem overwhelming, especially if you're not familiar with the intricacies of accounting. But don't worry – I've got you covered. As a CPA with years of experience helping clients navigate tax savings strategies, I'll break down the essentials in a way that's easy to understand.

Federal Income Tax Rates?

Let's start with federal income taxes. The top federal income tax rate is currently 39.6%. This might seem high, but it's worth noting that rates were as high as 90% during the Eisenhower administration! While income taxes are significant, affluent families often find that estate and gift taxes can be an even bigger concern.

Estate and Gift Taxes?

Federal estate and gift taxes start at 40% for estates worth $11.2 million or more (as of 2018). This means that avoiding estate taxes can be just as important as minimizing income taxes for wealthy families. Here's a basic rundown of how estate taxes work:

1.? Calculate the Gross Value of Your Assets:? Add up the value of all the assets you own at the time of your death. This includes real estate, stocks, bonds, mortgages, notes, cash, life insurance, annuities, and any other property you have control over.

2.? Subtract Allowable Deductions:? These deductions can include funeral costs, estate administration costs, mortgages and debts, charitable bequests, and bequests to your surviving spouse.

3.? Add Back Taxable Gifts:? Include any taxable gifts made after December 31, 1976.

4.? Calculate Your Tentative Estate Tax:? Determine the tentative estate tax based on the above values.

5.? Subtract Gift Taxes Paid:? Deduct any gift taxes paid on post-1976 gifts.

6.? Subtract Unified Credit Exemption:? This credit is designed to eliminate taxes on estates below a certain amount.

7.? Subtract Other Credits:? Deduct credits for state death taxes paid and federal gift taxes on pre-1977 gifts.

8.? Consider Generation-Skipping Tax:? If you transfer assets to someone more than one generation below you, there may be an additional tax.

Strategies to Reduce Estate Taxes?

If your net worth is high enough to make your estate taxable, here are some strategies to consider:

?1. Lifetime Gifts:?

Giving gifts during your lifetime can reduce your taxable estate and transfer future appreciation on gifted assets to your beneficiaries. You might even want to use up part or all of your unified credit while you're alive.

?2. Family Limited Partnerships and LLCs:?

By placing assets in family limited partnerships (FLPs) or limited liability companies (LLCs), you can create valuation discounts. This allows you to start gifting assets to your heirs without giving up control.

?3. Credit Shelter Trusts:?

These trusts ensure that both you and your spouse fully utilize the unified credit, which can significantly reduce estate taxes.

?4. Private Annuities and Trusts:?

Private annuities and private annuity trusts allow you to eliminate assets from your taxable estate by selling them.

?5. Irrevocable Life Insurance Trusts:?

These trusts can exclude life insurance death benefits from your taxable estate and create a tax-free pool to pay estate taxes. This is often referred to as “paying taxes with discounted dollars.”

Tax Savers?

The 2001 tax act gradually reduced estate taxes over a decade and increased the unified credit amount. While there was no estate tax in 2010, it returned in 2011. Here are some additional tips:

?1. Special Valuation Discounts for Family Farms and Businesses:?

If you own a family farm or business, you might be eligible for valuation discounts of up to $820,000 (for farms) and $1,100,000 (for businesses). If these assets make up 35% or more of your estate, you can spread tax payments over 14 years.

?2. Annual Exclusion Gifts:?

You can give up to the annual exclusion amount ($15,000 per person per year in 2018) to as many beneficiaries as you like. Gifts exceeding $15,000 to a single person in a year are taxable and count against your unified credit. However, no actual tax is due until your total lifetime taxable gifts exceed $11.2 million.

?3. Educational and Medical Expenses:?

You can give more than $15,000 per person for educational (tuition only) or medical expenses if you pay the provider directly.

Action Items?

Now that you have a basic understanding of how federal income and estate taxes work, here are some steps you can take to save money on your taxes:

?1. Evaluate Your Assets:?

Start by assessing the value of your assets and determining if your estate could be subject to estate taxes.

?2. Plan Your Gifting Strategy:?

Consider making lifetime gifts to reduce your taxable estate. Remember to take advantage of the annual exclusion amount and pay educational or medical expenses directly to providers when possible.

?3. Explore Trusts and Partnerships:?

Look into setting up family limited partnerships, limited liability companies, and various types of trusts to protect your assets and reduce estate taxes.

?4. Consult a Professional:?

Work with a CPA or tax professional to develop a comprehensive tax savings strategy tailored to your specific situation. This can help ensure that you maximize your savings and comply with all tax regulations.

?5. Stay Informed:?

Tax laws can change, so it's important to stay up-to-date on the latest regulations and opportunities for tax savings.

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