Calculating estate taxes can be a daunting task, especially when your estate is composed of valuable assets like properties and investments rather than cash. Understanding how estate tax is calculated is crucial for ensuring your heirs can retain those assets without financial strain. Proper valuation and strategic planning, such as using an irrevocable life insurance trust (ILIT), can safeguard your family’s legacy. Let’s delve into how you can accurately value your estate and prepare for the inevitable tax implications.
One of the toughest questions we encounter when working with many of our clients is how much they can expect to pay in estate taxes when the bulk of their estate is made up of assets other than cash, like properties and investments. That’s because calculating how much you’ll need to pay in estate tax can be a bit complicated when you’re dealing with assets that appreciate. It’s something that people might learn the hard way — how accurately you can calculate your estate value will determine if their heirs can keep those properties in the family, or if they’ll need to sell them off.
An accurate evaluation coupled with an irrevocable life insurance trust (ILIT) can ensure that your heirs have the funds they need to cover your final tax bill, even when the value of those assets is difficult to predict. Since you can never precisely predict the timing of death, or the estate tax laws in effect on that date, the answer is to insure for more than you may need. After all, life insurance is basically purchased with discounted dollars and is essentially “money on sale.’ After all, if the money the life insurance created was good enough for Uncle Sam, it’s good enough for your family and your favorite charities.
Understanding How Estate Tax is Calculated
When it comes to estate value, the only straightforward thing you can really calculate is cash. However, most people don’t hold their estates in cash. Instead, their estates are made up of property, investments, and other less-liquid assets. Usually, these valuations are determined based on the date of death of the estate owner.
Aside from cash, the value of investment, bank, and retirement accounts are the easiest to calculate. On the date of your death, it’s the stated balance of the account that’s used to calculate its value. The interest rates on these accounts can be predicted based on past data, so it can be reasonably easy to predict where they’ll be on a future date.
The next area you’ll need to look at is stocks you hold outside of investment accounts. This can be harder to predict because this is evaluated by averaging the high and low per-share price on the valuation date, times the number of shares owned. So, for example, if the stock has a low of $70 per share and the high was $85 per share, and you owned 1,000 shares, the overall stock evaluation would look like this:
[($70 + $85)/2] * 1,000 = $77,500
or
[(high value + low value)/2] * amount of shares = total value
Finally, real estate can be the most difficult to evaluate because it’s based on the fair market value of the asset on the date of your death. Just about anything can impact the fair market value of a real estate asset and cause that value to change drastically. For example, say you owned a warehouse in an undeveloped part of town. Then that part of town became very trendy. That trendiness would push the value of your warehouse up significantly because real estate is heavily affected by supply and demand.
While that warehouse may be a great investment, it can be pretty tough on your heirs come estate tax time because the value can be quite a bit more than you anticipated. As such, it’s important to regularly check in on real estate asset value because its value can be quite unpredictable.
With interest-bearing accounts, using historical data can give you a good idea of how much these funds will be worth in the future. Real estate requires more active management to gauge its changing value. Calculating all of these categories together will get you to your gross estate amount. However, you pay taxes on your net estate, which means evaluating your debts and other liabilities in conjunction with that estate.
The Expenses That Reduce Your Gross Estate
Pretty much anything you owe gets reduced from your gross estate, so any outstanding loans, mortgages, lines of credit, and other debts will be the first thing used to reduce your overall estate. Then, charitable gifts given or those held in charitable remainder trusts can be reduced from your estate as well. Finally, your executor is allowed to deduct the expenses related to settling your estate. Generally, you can use 5% of the overall gross estate as a benchmark for that reduction.
After all of those deductions, you’ll be left with a net estate value. At that point, you’re entitled to take a $11.7 million federal estate tax exemption. Anything above and beyond that amount is considered your taxable estate, and those taxes can be pretty high. They can reach up to 40% in some cases.
That taxable amount is the target amount that you either need to set aside for taxes or reduce to eliminate the burden of your estate taxes. This can be accomplished by using an ILIT as an estate tax shelter.
Using an ILIT to Protect Your Estate from Taxes
You can either use an ILIT to provide a pool of funding for those eventual estate taxes, or you can use that ILIT as a place to transfer value to reduce your overall estate. How you manage this will depend on how liquid your estate is.
For example, if your estate is heavier in cash assets and investment accounts, it might be wiser to take the funds out of those accounts and use them to purchase life insurance policies through a trust. If your estate is heavier in property and other assets, which are harder to liquidate, it’s likely a better idea to use the ILIT as a fund for paying out estate taxes later on.
Either way, the first step to managing this is doing a proper evaluation of your estate. Using the historic performance of your accounts or property can give you a better idea of how much they’ll grow in the future. Using life insurance to either reduce the overall taxable amount of your estate or to cover your estate taxes down the road can be a good tactic for managing this. Contact a Howard Kaye advisor at 800-DIE-RICH for more information on valuing your estate and covering the tax bill in advance with an ILIT.
