Federal Estate Tax

The Federal Estate Tax Exemption and Its Effect

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The federal estate tax is a tax on your right to transfer assets to your heirs and beneficiaries after your death. Assets that can be taxed include cash, stock, bonds, real estate, and other valuable assets.

Learn how the estate tax works and which estates are exempt from paying it.

Key Takeaways

  • Only the part of your estate that is over the federal exemption is taxed. In 2021, this was $11.7 million; in 2022, it's $12.06 million.
  • Estate tax rates range from 18% to 40%.
  • Your estate isn't subject to tax if it's inherited by a spouse.
  • An estate tax is paid by the estate on assets over a certain amount; an inheritance tax is paid by the beneficiary on any inherited assets.

How Does the Estate Tax Work?

The total tax due is calculated by adding up the fair market values of all the decedent's assets as of their date of death. The assets that are part of your estate can include:

  • Cash
  • Stock, bonds, and other securities
  • Business interests
  • Real property
  • Trusts and annuities
  • Insurance
  • Other valuable assets

The total of all these assets is known as your "gross estate."

The fair market value of your assets is not necessarily what you paid for them. Instead, it's what they are worth at the time of your death. The executor or administrator of the estate can also elect to have everything valued on an alternate date six months later instead.

Using the six-month alternate valuation date can be beneficial if an estate is expected to lose value over six months so its estate tax would be calculated on less.

Credits and allowable estate tax deductions are subtracted from your gross estate. These can include bequests you leave to charity, the funds used to pay off your mortgage or other debts, and any costs and fees incurred to settle your estate.

Only assets that are worth more than a certain threshold are taxed at a percentage of their value. This threshold is known as the "estate tax exemption." For 2021 (the tax return filed in 2022) the exemption is worth $11.7 million. For 2022, it is $12.06 million.

The rate at which your estate is taxed depends on how high over the exemption limit your assets are. The rate ranges from 18% for assets that are $10,000 more than the exemption to 40% for estates that are $1 million or more above the exemption.

History of the Estate Tax

The estate tax exemption was initially indexed for inflation under the provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRUIRJCA). This law also set the top estate tax rate at 35%.

These provisions were supposed to remain in place until December 31, 2012. At that point, the federal estate tax laws were supposed to revert back to the ones in effect in 2001. This meant that the federal estate tax exemption would drop all the way down to $1 million, and the tax rate would jump to 55% on January 1, 2013.

Then Congress and President Barrack Obama acted in the early days of 2013 to pass the American Taxpayer Relief Act (ATRA). This law made permanent the changes to the rules governing estate taxes, gift taxes, and generation-skipping transfer taxes that were previously implemented under TRUIRJCA.

Then came the Tax Cuts and Jobs Act (TCJA) in 2018. The TCJA doubled the exemption, which was already indexed to keep pace with inflation.

Who Is Subject to the Federal Estate Tax?

The estates of all U.S. citizens are subject to the federal estate tax, but very few estates actually have to pay it because of the exemption. Only estates whose values exceed the exemption after deductions are made, and credits are taken, are subject to the federal estate tax on the balance.

The Unlimited Marital Deduction

One of the most significant deductions for the estate of a married decedent is the unlimited marital deduction.

Remember, the estate tax is based on an estate's value after all available deductions and credits have whittled it down. The unlimited marital deduction allows a decedent to take a deduction for everything transferred to the surviving spouse at death.

An estate can escape taxation entirely if the decedent was married and left everything to their surviving spouse.

Marital assets would be subject to the estate tax when the surviving spouse dies, unless that spouse has remarried and again passes the property to the current spouse. This would effectively mean disinheriting any children the couple has.

What Is Estate Tax "Portability"?

The Internal Revenue Code also provides for portability of the estate tax exemption between married couples. This provision was first introduced under the TRUIRJCA and was then made permanent. Portability means that if you are married and pre-decease your spouse, you can pass any of your unused exemption to them to use for their own estate.

For example, if your father left an estate worth $10 million when he passed away in 2021, he still had $1.7 million left after applying the 2021 exemption of $11.7 million. If your father was married at the time of his death, he can pass that remaining $1.7 million from his estate to his spouse. Now your father's spouse can shelter $1.7 million more than whatever the estate tax exemption is at the time of their death.

A federal estate tax return must be filed if the executor of the estate wants to give the portability bump to the surviving spouse, even if the decedent's estate doesn't owe a tax because its value doesn't exceed the exemption amount. The estate tax return would simply indicate that the portability option is being exercised, alerting the IRS to this fact.

How to File an Estate Tax Return

An estate must file a federal estate tax return, Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, when a gross estate exceeds the federal estate tax exemption for the year of the decedent's death.

Form 706 must be filed with the IRS within nine months of the decedent's date of death. The estate tax payment is due at the same time Form 706 is due.

An automatic extension can be applied for by using Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes. The payment itself will begin accruing interest after the nine-month deadline.

Estate Tax vs. Inheritance Tax

Estate and inheritance taxes are two separate things, but they're often confused. They are often lumped together under the unfortunate name "death taxes."

The estate tax is based on the value of a decedent's entire estate after deductions, credits, and the estate tax exemption are subtracted and applied. It's payable by the estate.

An inheritance tax is payable by the beneficiary who receives property from the estate. It's based on only the value of those inherited assets. It would apply if you inherit property, even if the estate were large enough to qualify for a federal estate tax. If you are the beneficiary, you are responsible for paying any inheritance tax. Some people include provisions in their wills to have the estate take care of this burden for their heirs.

The federal government doesn't impose an inheritance tax, but six states do as of 2020: Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax rate is typically based on how closely related the beneficiary is to the decedent, and the closer the better. Spouses are almost invariably exempt, and some other relatives may be as well.

Frequently Asked Questions

Is there an estate tax at the state level?

Twelve states have an estate tax: Washington, Oregon, Hawaii, Minnesota, Illinois, Vermont, Maine, Connecticut, Massachusetts, Rhode Island, New York, and Maryland. The District of Columbia also imposes an estate tax.

How can I reduce estate taxes?

The smaller your estate at the time of your death, the less of it will be subject to estate taxes. Giving away assets before your death reduces the size of your estate's tax burden, as long as you care careful about federal gift tax rules. You can also leave bequests to charity. If you leave your estate to your spouse, you can avoid estate taxes, though they might not be able to.

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