In order to be able to answer the question that serves as the title of this post, we have to provide some broad background information about all taxes on postmortem asset transfers.
Federal Estate Tax
There is a federal estate tax in the United States, and it carries a 40 percent top rate. Most families never have to be concerned about this tax, because there is a high credit or exclusion that can be used to transfer a certain amount tax-free.
Only the portion of an estate that exceeds this amount would be subject to taxation. In 2020, the federal estate tax exclusion is $11.58 million.
There is no tax to pay on transfers to your spouse, because there is a marital estate tax deduction. It should be noted that this only applies to transfers to spouses that are American citizens.
The estate tax exclusion is portable between spouses, so a surviving spouse could use a deceased spouse’s exclusion, but only by taking the proper steps.
Inheritance Tax
As we have stated, the estate tax is applied on the entire taxable portion of an estate before it is transferred to the heirs. An inheritance tax is a levy with an entirely different structure.
This type of tax is levied on transfers to all inheritors that are not exempt. As a result, there could be multiple impositions of the tax when one estate is being administered.
There is no federal inheritance tax, but there are six states that have their own inheritance taxes. Fortunately for us, New York is not one of them. There is an inheritance tax in New Jersey, and before their estate tax was repealed, they had both an inheritance tax and an estate tax.
State-Level Estate Tax
That’s not the final word when it comes to taxation on inheritances. There are 12 states in the United States that have state-level estate taxes, and we are in that group. It is possible to face exposure on the state level even if you are exempt from the federal tax, because the New York estate tax exclusion is $5.85 million.
A major negative that we face here in the Empire State is the so-called estate tax exclusion “cliff.” If the value of your estate is more than 5 percent over the amount of the exclusion, you cannot use the exclusion at all. The entirety of your estate would be subject to the tax.
Gift Tax
You cannot simply give gifts to avoid the federal estate tax because there is a gift tax in place that is unified with the estate tax. The exclusion is a unified exclusion that includes lifetime gifts along with the value of the estate that will be transferred after your death.
However, there is a $15,000 per year, per person gift tax exemption that sits apart from the unified exclusion. You can give up to $15,000 to an unlimited number of gift recipients in a given year free of taxation without dipping into your available unified lifetime exclusion.
In New York, there is no state-level gift tax, so gift giving to avoid the estate tax is a possibility. However, there is currently a three-year “clawback” provision in the law. Gifts that you give within three years of your passing would be included as part of your estate when your tax liability is being calculated.
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