Sure, let’s break down this complex topic into simpler terms.
You know how people say the only sure things in life are death and taxes? Well, when you combine the two, it’s even less popular. This is where the federal estate tax, or as some call it, the "death tax", comes into play. For years, some politicians have been trying to lower or even get rid of this tax. They’ve managed to weaken it since 2001, even making it disappear for a year.
But the federal estate tax isn’t the only one out there. Some states have their own versions, and there are also different inheritance taxes. Plus, the federal tax doesn’t just apply to the money you leave behind when you pass away. It also includes a gift tax on large amounts of money you give away while you’re still alive.
Let’s dive deeper into how these taxes work. Understanding them won’t make death or taxes disappear, but it can help you plan better.
When politicians talk about the estate tax, they’re usually referring to the federal one. This tax applies when someone dies and leaves behind a lot of wealth. The IRS takes a chunk of that wealth as tax before it’s given to the heirs. Some people think this is unfair because the person already paid taxes on that money when they earned it, so it shouldn’t be taxed again when they die.
But here’s the thing: most people never have to pay the federal estate tax. According to the CBPP, less than 1 out of every 1,000 Americans have any tax collected from their estates. As per IRS rules, a person who dies in 2021 can leave up to $11.7 million in assets before the government takes any of it. For married couples, this amount doubles, so they can leave up to $23.4 million to their heirs tax-free.
At first glance, it seems easy to avoid paying the estate tax, no matter how much money you have. You could just give away your money to your intended heirs while you’re still alive. As long as you gave away enough to reduce the value of your estate to $11.7 million or less, it wouldn’t be taxed.
But the government has already thought of that loophole. To close it, the IRS charges a “gift tax” of up to 40% on any large sums you give away during your lifetime. That includes not only cash, but also items with a significant cash value, like jewelry and cars.
Under IRS rules, as of 2021, you can only give away $15,000 worth of gifts to any person in a year without paying the gift tax. However, this limit doubles for a married couple. For example, a couple could give up to $30,000 per year to each of their children or grandchildren without triggering the tax.
When you make a gift that’s higher than that amount, you have a choice. You can either pay the gift tax right away or count the gift against your personal estate tax exemption. This is the total amount of your wealth you can exempt from the estate tax, both during your life and after your death. Using this credit, you can give away up to $11.7 million during your lifetime without paying tax on it. But if you do use the entire amount, all of your estate becomes subject to taxation after your death.
Moreover, the personal exemption can change. Although it’s $11.7 million in 2021, it could be more or less than that amount in the future.
There are a few exceptions to the gift tax or the personal exemption. These include gifts to your spouse, tuition payments, medical bills, and charitable and political donations.
To figure out how much your estate is worth, the IRS starts by calculating your gross estate. This includes everything you own at the time of your death: the cash in your bank accounts, securities, real estate, whole life insurance policies, trusts, annuities, business interests, and other property.
After figuring out your gross estate, the IRS starts taking off deductions that reduce the amount of tax that’s due on it. These include the marital deduction for money or property you leave directly to your spouse, the charitable deduction for money you leave to a tax-exempt charity, mortgages and other debts you owe, the administration costs of your estate, and any losses during the estate administration process.
Calculating your taxable estate isn’t the final step in the process. Before actually calculating the estate tax that’s due, the IRS has to subtract your applicable credit — the amount you have left of the $11.7 million you’re allowed to give away, tax-free, both before and after your death.
If your taxable estate is more than your applicable credit balance, then the excess is subject to tax. For instance, if your taxable estate is $15 million, then after the $11.7 million credit, $3.3 million is taxable. This entire sum is taxed at the federal estate tax rate, which is currently 40%. That means the federal government gets to collect $1.32 million in taxes, leaving a total of $13.68 million for your heirs.
If you’re like most Americans, your heirs will never have to worry about filing a federal estate tax return. However, that doesn’t mean they won’t have to pay any taxes on the money they inherit from you. Several states also charge their own taxes on money that’s passed along after death.
These state taxes fall into two types: estate taxes and inheritance taxes. According to the Tax Foundation, 12 U.S. states and the District of Columbia currently have estate taxes, and six states have inheritance taxes. One state, Maryland, charges both kinds of tax.
In most cases, estate and inheritance taxes only affect people with a lot of money to leave. Less than 0.01% of all taxpayers get hit by the federal estate tax, and no state charges estate taxes on estates worth less than $1 million.
However, if you want to make sure you keep the tax burden as low as possible for your heirs, there are several things you can do ahead of time. These include making smaller gifts regularly, doing the math on bigger gifts, giving to charity, sharing with your spouse, and checking your state laws.
One thing often overlooked in all the furor over the estate tax is that it’s a useful source of revenue for the government. The money raised by estate and capital gains taxes goes to support important projects that Americans depend on, from the armed forces to interstate highways to food aid for people in need. According to the CBPP, getting rid of the federal estate tax completely would either take $250 billion away from these essential projects over a 10-year period or tack it on to the ever-growing federal budget deficit. Compared with these choices, maybe skimming a little bit of money off the estates of multimillionaires isn’t such a bad option.
In fact, many Americans today believe Congress has already gone too far in cutting the estate tax. In a 2019 survey by Morning Consult, 50% of respondents said they would favor a plan proposed by Senator Bernie Sanders to impose the federal estate tax on all estates over $3.5 million. Only 33% said they would favor a Republican plan to eliminate the tax entirely.
