What is the estate tax?
The estate tax is a tax on assets and property transferred from one person to the person’s heirs and beneficiaries. Because the bulk of such transfers usually occur at the person’s death, the estate tax is sometimes called a “death tax”. Only very large estates, whose total value exceeds a certain dollar amount, owe this tax. For the federal estate tax, this dollar amount has risen steadily in recent years and is $5.43 million in 2015. Estates at or below this limit are exempt from estate tax. Fewer than two out of every 1,000 people would have to pay any estate tax; 99.85% of estates owe no tax.
Note that the dollar limit applies to total gifts, made during both a person’s life and at death. For example, if a person had given $1 million to their heirs during their lifetime, and also left $5 million to their heirs when they passed away in 2015, the $5 million transfer would be subject to the estate tax because the $5.43 million lifetime limit had been exceeded. If the donor had made no gifts to beneficiaries in their lifetime, then a $5 million transfer would be less than the lifetime limit and would not be subject to the estate tax.
How is the estate tax computed?
To compute the federal estate tax, the total of the person’s belongings and certain interests at the date of death are documented on IRS Form 706. This total, called the “Gross Estate”, includes cash, stock, real estate, insurance, annuities, and business interests. The actual market value of each asset is used, not the price it was purchased for.
After the Gross Estate is figured, various deductions are taken. These deductions include any debts, mortgages, property donated to charity, and estate administration expenses. The value of property left to the person’s surviving spouse is also deducted, if the spouse is a U.S. citizen. Finally, the value of gifts made during the person’s lifetime are added (yes, the IRS expects you to keep track of the amount of gifts you make to your heirs). After taking deductions, the “Taxable Estate” is arrived at. If this value exceeds the exemption limit, the estate tax applies.
How can I reduce or avoid estate tax?
Gifts are a way to reduce the size of your estate and thereby also reduce the estate tax or chance that you’ll have to pay a tax. Under law for 2015 you can gift up to $14,000 per recipient per year in cash or other assets and it will not apply to your exemption limit. The recipient also does not have to report the gift as taxable income. You can also give an unlimited amount directly to a medical or dental care provider or educational institution on behalf of someone else without incurring a gift tax.
You and your spouse could also set up an AB trust and leave your assets to the trust instead of your heirs directly. Upon one spouse’s death the surviving spouse would receive income from the assets in the trust. Upon the second spouse’s death the heirs would have control of the assets. Because the couple never passed the assets directly to the heirs, no estate tax is owed.
Such trusts are complex to administer and come with fees and restrictions however, and with recent increases in the estate tax exemption limit they may no longer be needed for many couples.
In addition to the federal estate tax, many states also have their own estate tax, and a few have an inheritance tax, which is paid by the beneficiary. Depending on where the donor lived, a state estate tax may be owed even if a federal estate tax is not, because the dollar amount is much lower in some states than the federal dollar limit. In any case, you should consult a financial advisor or tax attorney regarding ways to protect your estate from taxes.
For more information
For more information about the federal estate tax, consult the IRS estate tax page.
For more information about state estate taxes, consult the tax authority for that state.