As with other aspects of the tax code, the Tax Cuts and Jobs Act of 2017 significantly changed the way estate tax applies to Americans. The 2021 limit, after adjusting for inflation, is $11.7 million, up from $11.58 million in 2020. Any funds after that will be taxed as they pass on to heirs, at a rate that varies by the amount being passed on.
These taxes don't apply to funds being left to spouses—one of the many significant financial benefits of marriage.
Changes in Estate Tax Over Time
The amount a person can pass on before facing taxes is known as the "lifetime gift tax exemption." The graph below illustrates how the lifetime gift tax exemption grew between 2000 and 2021. As you can see, the biggest leap occurred in 2018, after the Tax Cuts and Jobs Act took effect.
The Estate Tax Is Tied to the Lifetime Gift Tax Exemption
Lifetime gift tax exemption most commonly comes into play in scenarios of estate and inheritance, but that isn't the exemption's only application.
You can give a person $15,000 every year without having to pay gift taxes on the money. (There are exceptions to this rule, such as in cases of tuition and college expenses, where there are no limits.) If you are married, you and your spouse can combine your exemption, taking it to $30,000.
If you want to give more than the annual exemption amount, you can pay the tax on the gift, or you can use part of your lifetime gift tax exclusion allowance. Let's say you and your spouse give your child $100,000 this year. Of the total gift, $70,000 would be subject to the gift tax. However, you could include it as part of your lifetime gift tax exclusion allowance and avoid paying any taxes. Then, when you and your spouse die, you could only avoid taxes on a combined total of $23.33 million, instead of $23.4 million.
The graph below shows how the top estate tax rate has changed from 2000 to 2021.
Estate Tax Rate Varies by Amount
You may have read that the federal estate tax rate is 40%. However, that isn't the whole story. That 40% rate is the top tax rate, and it only applies to families leaving behind more than $1 million—after accounting for the lifetime gift tax exclusion. In other words, your estate would have to be worth more than $12.7 million for it to face the 40% tax rate. The lowest tax rate, for those whose estates total just beyond the $11.7 million lifetime gift tax exclusion, is 18%.
Benefits to Using Lifetime Gift Tax Exclusion Early
Some families may find that it makes sense to begin taking lifetime gift tax exclusions well before they die and bequeath their entire estate. Doing so can give the assets time to grow through dividends, interest, and rents within their portfolio.
It's best to speak to a financial planner or advisor with a history of satisfactory rates of returns on assets about how to best transfer wealth to heirs. You may also be able to make use of liquidity discounts in family limited partnerships, for example, or discounted family loans at the lowest applicable Treasury rate. Done correctly, a family can minimize the tax burden while building wealth to pay off any taxes that may be due at the time of the estate transfer.
State Estate Taxes Vary
The figures so far have dealt with the federal estate tax. However, some individual states impose an estate tax, as well. In Maryland, for example, an estate is subject to a tax of up to 16% if its gross value is at least $5 million. In Connecticut, there's an inheritance tax. It is similar to an estate tax, but the burden usually falls on the one receiving the money rather than upon the estate itself.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to them. For current tax or legal advice, please consult with an accountant or an attorney.