What Is Estate Tax, and Who Is Responsible for Paying It?
It’s said that the only certainties in life are death and taxes. And for the wealthy, death often means yet another tax bill.
Estate taxes are levied by the federal and some state governments on the value of a deceased’s assets, minus certain exclusions. The tax typically only affects the wealthiest Americans with estates valued well into the millions of dollars, but it’s important to understand how the tax works as you plan for retirement — or on the chance that a wealthy relative leaves you an estate in their will.
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Estate Tax Definition
The IRS defines the estate tax as a tax on your right to transfer property after your death. The actual tax amount is determined by the fair market value of your assets, which may include real estate, cash, securities, annuities, business interests, and other tangible property, called the “Gross Estate.”
From there, the IRS allows certain deductions, including mortgages, debts, assets that are passed on to a spouse or charity, and expenses associated with the administration of the estate. In some cases, some or all of business or farm value can also be deducted to determine the net estate value. If that value exceeds the exemption threshold, then that excess is taxed at the prevailing rate.
Estate taxes are levied at the federal level, but also by several states: Connecticut, Hawaii, Illinois, Maine, Massachusetts, Maryland, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. The District of Columbia also charges an estate tax. Because the state thresholds for the state estate tax are lower than the federal limits, some estates may not be taxed federally, but still billed by the state.
Estate taxes are not applicable if the estate is transferred to a surviving spouse.
Estate Tax Examples
Again, because the estate tax thresholds are high, typically only wealthy individuals are subject to the tax. Currently, the federal threshold is $11,400,000, and the tax applies to any estate value in excess of that amount.
To see how the taxes are applied, consider these scenarios:
- John, a resident of Maryland, is the beneficiary of his parents’ estate. They leave him several homes and bank accounts with a total value of $8,500,000. Once the mortgages and debts are deducted, the gross value of the estate is $6,250,000. Because John doesn’t meet the federal threshold, he does not owe federal estate taxes. However, because John’s parents were also Maryland residents, and Maryland levies taxes on estates valued at $5,000,000 or more, he must pay estate taxes to that state. He’ll be taxed on $1,250,000 of the estate, at a rate of no more than 16%.
- Mary is the beneficiary of an estate in California. The total value of the estate after deductions is $15,400,000. She is required to pay estate taxes to the federal government on $4 million. According to the IRS, the tax is $345,000 plus 40% of the amount in excess of $1 million. This makes the total federal estate tax bill $1,545,000 ($345,000 plus 40% of $3 million, or $1.2 million).
- When Steve’s grandmother dies, he inherits her estate, valued at $1.2 million. Because there is no state estate tax in his home state, and the estate is well below the federal thresholds, he does not have an estate tax bill.
Estate Tax vs. Inheritance Tax
Although some people may use the terms estate tax and inheritance tax interchangeably, they actually refer to two separate taxes. The estate tax is the tax paid on the total value of the estate after all debts have been paid. The tax is paid by the estate prior to its transfer to the beneficiary.
An inheritance tax, however, is paid by the individual recipient of a bequest from a will. For example, if your grandmother leaves you money, you may be required to pay taxes to your state on the full amount if it exceeds certain thresholds. This means that in some cases, your inheritance could be taxed twice: first by the federal (and possibly state) government on the entire estate, and then again by your state on any money you receive.
Not all states have inheritance taxes. Currently only Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania tax residents on inheritances.
Further complicating matters is the existence of gift taxes. Gift taxes are separate from estate and inheritance taxes, and levied on money or property given to others without any expectation of something in return. Usually, the person giving the gift is responsible for paying taxes on the gift, but only if it exceeds the annual exclusion threshold (currently, $15,500). In other words, if a parent wants to write a child a check for any amount up to $15,500, they may do so without any tax implications.
One way to determine whether the rules for a gift tax apply is whether the donor (or person making the gift) is still alive. If so, then the money is subject to gift tax rules. If the money comes from someone deceased, then the estate and/or inheritance tax rules apply.
How Estate Taxes Work
To calculate the estate tax bill, first determine the Gross Estate amount, and make any qualified deductions such as debts and funeral expenses. This is the net estate. The IRS then requires adding to the net estate the value of any taxable gifts you made going back to 1977, before deducting the unified credit, or the value of your estate that’s exempt from taxes. As of 2020, the unified credit is $11,580,000, but the amount changes annually. Only the value of your estate in excess of that amount will be taxed on a sliding scale of 18 to 40%.
State estate taxes are calculated similarly, but the qualifying deductions may be different. Because the state exclusion thresholds are lower than the federal exclusions, you may need to pay taxes to the state and not the feds; however, if your state levies estate taxes and you have to pay federal taxes, you’ll have to pay state as well. State estate taxes are not handled by the IRS, and you will need to file directly with the state.
What Is the Estate Tax Rate?
As of 2020, the highest federal marginal estate tax rate is 40%. The tax is levied on a sliding scale based on the value of the estate. The IRS charges a flat tax amount on the taxable value of the estate, and then a percentage ranging from 18 to 40% on the amount over the taxable threshold.
For example, if the taxable amount of the estate is between $40,000 and $60,000, the base tax is $8,200. If the taxable value is $52,000, then the total tax is $11,080, or $8,200 plus $2,880, which is 24% of the $12,000 in excess of the $40,000 threshold. The tax rates and thresholds are found in the instructions for Form 706.
State estate tax rates are typically much lower. They vary based on the taxable value of the estate, with most ranging between 5 and 16%. One notable exception is Washington, which levies a 20% tax on estates with a taxable value in excess of $9,000,000.
Estate Tax Threshold
As of 2020, the federal government taxes estates valued at $11,580,000 or more. Only the value of the estate in excess of that threshold is taxed. In other words, only $820,000 would be taxed on an estate worth $12,400,000, but an estate worth $20 million would be taxed on $8,420,000.
At the state level, the estate tax thresholds are much lower. As of 2020, the following exclusion thresholds apply in states that levy estate taxes.
- Connecticut: $5,100,000;
- District of Columbia: $5,681,760 (2019);
- Hawaii: $5,000,000;
- Illinois: $4,000,000;
- Maine: $5,800,000;
- Maryland: $5,000,000;
- Massachusetts: $1,000,000;
- Minnesota: $3,000,000;
- New York: $5,850,000;
- Oregon: $1,000,000;
- Rhode Island: $1,579,922;
- Vermont: $4,250,000;
- Washington: $2,193,000.
How to Pay Estate Taxes
Estate taxes are the responsibility of the executor of the estate. The IRS requires the estate to file Form 706 and pay the tax owed within nine months of the estate holder’s death.
You can request a six-month extension by filing Form 4768. An extension may be necessary if you cannot determine the full value of the estate, or if you have a valid reason that filing and paying the taxes isn’t possible or practical within the given time. This form is to be filed and the taxes paid separately from your annual income taxes or any other tax returns you file annually.
Determining How Much You Owe
Determining how much you actually owe in estate taxes can be complex, and depends on a wide variety of factors. You need to deduct liabilities, including debts, mortgages, funeral expenses, charitable gifts, state estate taxes, and inheritance taxes. Finally, add the value of any gifts that were given tax-free to determine the value of the estate. If it’s more than $11,580,000, you will need to pay federal estate tax.
You can reduce the amount of your estate tax bill several ways, including:
- Using accumulated wealth;
- Making charitable contributions;
- Making tax-free gifts;
- Moving to a more tax-friendly state.
However, you cannot escape estate taxes if you owe them. Failing to pay the tax, or not paying enough, means major penalties and fines, so work with the executor of the estate and tax experts to determine what you owe and how to best pay the bill.
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This post was updated January 30, 2020. It was originally published January 30, 2020.