As Benjamin Franklin once said, “In this world nothing can be said to be certain, except death and taxes.” Taxes come in a wide variety of flavors (e.g., income taxes, property taxes, sales taxes, and gift taxes). But, perhaps one of the most misunderstood taxes is colloquially called the “death tax” – more appropriately called the “Estate Tax.” Critics call out the inherent unfairness of a tax that appears to tax assets that have already been taxed at least once before. The tax is conceptually dense and complicated by the fact that there’s a federal estate tax and many states (including Washington) impose a separate state estate tax that can operate independent from the federal estate tax. Let’s break it down.
Most People Will Pay Zero Estate Tax
You read that right. For the vast majority of Americans, the estate tax will simply not apply to the estate. Why? The federal estate tax is not imposed until estates become very large – more than $24,120,000 for a married couple in 2022. Only a very small slice of the population of the United States has that kind of wealth.
However, the state of Washington imposes an estate tax on estates valued at over $2,193,000 for 2022. This threshold will subject many more estates to the state estate tax than its federal counterpart. But with the median net worth for American families at around $121,700 (Federal Reserve’s 2019 Survey of Consumer Finances – the most recent data available), clearly most American families will not reach the threshold for either the state estate tax or the federal estate tax.
What is my Estate?
Remember that your estate includes everything you own. Everything. Real estate and personal property and cash and investments. Notably, your estate also includes any life insurance death benefit you may have. Life insurance is generally not subject to income tax, but it is part of your estate for the calculation of the estate tax. That fact alone causes many more families to have taxable estates.
The Estates Over $2,193,000
If you calculate that your estate with your spouse is valued at over the above number, what is the tax? The tax is 10% of the first million dollars above $2,193,000. If you and your spouse are potentially subject to the estate tax, one of the first ways to mitigate the effects of the tax is with a type of trust commonly referred to as a Credit Shelter Trust.
Credit Shelter Trust
Let’s assume you and your spouse have a gross estate of $4 million. Our concern then is the $2.193 million Washington Estate Tax. Because Washington is a community property state, it is probably safe in many marriages to assume that one half of the $4M is owned by each spouse ($2M each). Individually, each is under the threshold for the Washington Estate Tax. But, if one spouse dies, let’s say the husband for purposes of this example, and leaves everything to the wife, then the wife’s estate is large enough to be taxable. This means that the estate tax will not apply to the husband’s estate, but it is setting up the wife with a tax when she leaves assets to the kids. So, one common solution is simply to not give the assets to the wife. Who then does the husband give the assets to? Enter the Credit Shelter Trust. The first to die can instead give his or her $2M (or up to $2,193,000) to a credit shelter trust for the benefit of the surviving spouse. The wife gets to have all income off the trust and can dip into the principal of the trust for the things she needs. Notably, she does not own the assets of the trust so even though she benefits from the assets of the trust, she will not then get taxed as if she owned the trust. This kind of trust is relatively simple to add to your Will. In legal jargon, you’d have a Will with a testamentary credit shelter trust (the “credit shelter” terminology referring to the credit amount of $2,193,000 per person in Washington which otherwise evaporates if all assets are instead transferred to the surviving spouse outright).
By incorporating a trust like this, a married couple can now effectively transfer double the $2,193,000 to their children. That means that almost $4.4 million can pass free of any estate tax.
Of course, there is no singular solution to any type of planning – including estate tax planning. But the concept outlined above is a common solution employed by estate planning practitioners to mitigate the effects of the estate tax. As always, consult your tax and legal professionals for customized planning specific to your situation.
* Licensed, not practicing.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment Advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.