Benjamin Franklin once wrote that nothing is certain in this world except for death and taxes. He was certainly right, more so than he might have realized at the time. This is because there is something that combines both of them: estate tax.
We’re here to explain fundamentals of estate tax, so you can understand what it is,
who it applies to, and whether or not you actually have to pay it.
What is estate tax?
The government collects tax on an estate after its owner passes away if and only if that estate is bigger than any applicable exclusion limit.
However, if your spouse dies and their will transfers you their assets, then your spouse is typically not subject to estate tax because of spousal privileges. You can also call this privilege a “marital deduction.” However, when the surviving spouse passes away and the assets then transfer over to their heirs, if their value exceeds any local exclusion limits, they will then be subject to estate tax.
If you don’t plan for it, estate taxes can actually end up being ridiculously high. Because of this, careful estate planning is essential for those who plan to leave large assets to heirs or beneficiaries, like charities or organizations.
Is estate tax the same thing as inheritance tax?
Estate taxes and inheritance taxes are not the same thing. The main difference is that the government levies estate tax against an asset before it is passed on. It doesn’t collect inheritance tax until after the asset changes hands.
And, while estate tax applies to the entire asset, the amount of inheritance tax only applies to each individual’s portion of the asset. Inheritance taxes are also only still valid in some states, including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania.
You should also note that the same exclusion limits often apply to inheritance taxes and that the government bases these exclusions on how the heir is related to the deceased. For example, if you are their child, there is often no tax. But if you are a nephew or family friend, then there could be one.
What about gift tax?
Inheritance tax is also not the same thing as gift tax.
For something to be a gift, its owner needs to give it to you while they are still alive. Meanwhile estate and inheritance taxes occur after someone passes away.
However, you will often hear gift and estate taxes discussed together. This is because people often try to offload their assets to heirs towards the end of their lifetime in order to avoid having to eventually pay the estate tax.
But, according to the Internal Revenue Service (IRS), whether or not you intend a large asset transfer to be a gift, it still is, so there are rules that apply to your actions. Even so, there are still exclusion limits for taxable gifts.
In 2018, the limit per individual is $15,000. That means that this is the largest non-taxable amount you can receive as a gift as an individual. Each portion given away will not be added to the taxable about for the estate tax as well, but anything over it will be.
So, if a benefactor gives one person $30,000 that means that $15,000 of it qualifies to be levied by an estate tax, while the other $15,000 will be left alone.
Why do you have to pay estate tax?
You have to pay estate taxes because Uncle Sam always wants a piece of the pie! Just like Benjamin Franklin said, taxes from the federal government are pretty much unavoidable.
However, as we will explain, estate taxes typically only apply to the extremely wealthy and function as a way to tax wealth that grew unchecked while its owner was still alive. This is why New York University School of Law professor Lily L. Batchelder says, “It would be more accurate to call wealth transfer taxes [such as the estate tax] ‘silver spoon’ taxes, not ‘death’ taxes as their opponents prefer.”
Who pays estate tax?
Technically, these taxes can apply to every single United States citizen. We all have the possibility of having to pay a federal estate tax. However, there are many exemptions available from the IRS, so many Americans can avoid the tax altogether. To adjust for inflation, the exemption amount increases each year. In 2017, the exemption amount was $5,490,000.
To receive this exemption your net estate (gross estate or total assets less any other taxes and credits) must be less than the exemption limit. If the amount of the estate exceeds it, then only the surplus value is taxed.
Because of its high exemption threshold, in 2017, only two out of every thousand estates had to pay estate tax. As you can see, it’s definitely not a very common tax to have to pay.
History of the Estate Tax’s Structure
The 2010 Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (called TRUIRJCA for short—although this nickname doesn’t seem any easier!) indexed the estate tax exemption for inflation.
That meant that each year, the estate tax exemption would go up to make sure things remained fair and keep up with the reality of the economy. The tax rate was 35% at this time. These rules were originally only supposed to last until the end of 2012.
In 2013, the law intended the exemption limit to crash down to just $1,000,000 and the rate on estate above this amount would be 55%. However, in early 2013, Congress put through the American Taxpayer Relief Act (ATRA) making the adjustable rules more permanent. This 2013 law also introduced the idea of a surviving spouse not having to pay estate tax.
How do you file estate tax?
If your gross estate has a portion over the federal tax exemption limit the year that you die, then the manager of your estate must file a federal estate tax return called Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.
Your estate manager has to filed Form 706 with the IRS within nine months of your death or steep fines will apply. Payment of all the relevant taxes are also due at the same time as the form. However, while you can apply for an automatic extension to this deadline by filing Form 4768, pushing back the due date doesn’t stop the immediate accrual of interest.
In another common scenario, let’s say that the deceased’s estate doesn’t meet the minimum taxable value and the assets will all go to the surviving spouse. Tax law dictates that your estate manager must still file a federal estate tax return.
You still have to fill out and submit this form even though you don’t actually owe any taxes. The purpose is simply to alert the IRS to the situation. This way, if it comes up later, they will know you have been following the rules all along.
Can you avoid estate tax?
There are a few sneaky ways that you might be able to get around having to pay estate tax. The first and easiest would be to simply make sure that the value of your estate never surpasses the limit for non-taxable income.
However, even if it does, you can avoid the estate tax through careful estate planning. If you are married then you can use the tax minimum twice, once for each spouse. This doubles the amount of assets that can’t be subjected to estate tax.
The third way to reduce or eliminate your estate tax is to purchase a life insurance plan that replaces any assets given to charity or pay any leftover estate taxes. Be sure to speak your estate planner about the many different kinds of insurance policies and which one be the best fit for you personally.
There is one final way to avoid estate tax: spend your money! Remember, you can’t take it with you. Many individuals sometimes choose to try and spend their wealth until it dips down below the taxable income threshold. This is a drastic, but fun, way to avoid subjecting your estate to this round of taxes.
Remember, if you choose to simply dispose of your assets over the limit before you pass away, you would need to be very careful about this and not violate any inheritance or gift class laws along the way.