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Many people don't fully understand how the federal estate tax works. For instance, did you know that even if you're a millionaire, the estate tax won't necessarily apply to you? And even if it does, there are ways to reduce its impact. In this article, two of our experts shed some light on this oft-misunderstood tax.
The only households that get hit with the estate tax are relatively wealthy ones.
For the 2015 tax year, the IRS allows an exemption of $5,430,000 per person, which includes what you pass to your loved ones after death, as well as any taxable gifts given while you're still alive (more on this later). So long as you leave behind less than this maximum amount, your family will never feel the sting of the estate tax.
It's also important to note that cash isn't the only asset that counts toward the exemption amount. Other liquid assets such as brokerage accounts are also taken into account, as well as the fair-market value of real estate and other personal property, minus any liabilities. For example, if you own property outright that's worth $5 million and leave "only" $1 million in cash, your heirs could still get hit with the estate tax on the amount that exceeds the exemption limit.
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As far as gifts are concerned, there are special rules that you might find helpful if your estate's value happens to be over the exemption limit. The IRS allows a tax-free gift of up to $14,000 per year, per person, that won't count toward the exemption amount. If you're married, you and your spouse can each give gifts. So if you have a dozen grandkids, you and your spouse together could gift each of them $28,000 per year tax-free.
Any such gifts made while you're alive are completely separate from the estate tax. So, if you had an estate valued at $6 million, you could give $600,000 of it away as gifts over the years, and this would bring your estate's value under the limit so you could avoid the estate tax altogether.
One thing about the federal estate tax that few people understand is that even if you're rich enough not to have the tax entirely wiped out by the exemption that Matt talks about, there are several ways that you could reduce or eliminate any remaining estate tax liability. In particular, two deductions offer many people the potential to get unlimited relief from the estate tax.
One key break comes from the marital deduction. Any money you give to your spouse -- whether you make gifts during your lifetime or in your estate plan at death -- can qualify for an unlimited marital deduction so long as your spouse is a U.S. citizen or agrees to be bound by terms of a special type of trust arrangement. In some cases, this only postpones estate taxes -- e.g., when the surviving spouse then leaves any remaining property to children or other heirs. Yet the marital deduction can buy time to use other strategies, such as annual exclusion gifts, to reduce estate tax liability.
The other major deduction comes for charitable gifts. Property left to charity is eligible for an unlimited estate tax deduction, which is a big part of the reason why so many billionaire investors have made commitments to make major charitable donations in their estate planning. A campaign known as the Giving Pledge has enlisted more than 125 billionaires to give the bulk of their assets to charity either during life or when they pass away. Doing so takes advantage of the fact that without the gifts, up to 40% of the estate could go to the IRS.
Estate taxes can be huge for the rich, but there are ways around them. These two deductions are just the biggest of many strategies you can use to cut your estate tax liability.
The article 2 Things You Should Know About the Federal Estate Tax originally appeared on Fool.com.
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