By Dan Miller, WCI Contributor
Estate taxes and inheritance taxes are additional taxes levied when someone passes away. There is a federal estate tax, and several states also have an estate tax or an inheritance tax. Many people with high net worths don't like the idea of their estate being subject to additional taxes once they die. But the good news is that there is a relatively large exemption and a few other estate planning strategies to avoid or minimize your estate tax liability.
Let's explore what estate taxes are, how much someone might have to pay in estate taxes, and how to minimize them.
What Are Estate Taxes?
When a person dies, their estate may be subject to federal and/or state estate tax. The value of the estate of the decedent is usually calculated by the current fair market value of all of the items in the estate. Any amount over the exclusion amount is taxed at a rate of between 18%-40%, depending on the total value of the estate.
The IRS tax code has an exclusion amount that is fairly large and that will cover most estates. As of 2023, the estate tax exemption amount is $12.92 million for an individual and $25.84 million for a married couple (in 2022, it was $12.06 million for an individual). Those numbers are currently indexed to inflation. So, if your estate is basically less than $13 million, you will pay no federal estate tax. Additionally, transfers to surviving spouses are exempt from estate tax.
What Assets Are Subject to Estate Taxes?
All assets of a deceased person's estate are used to calculate the value of the estate. This would include real estate, cash, stocks, bonds, precious metals, insurance, or other valuable items minus any liabilities or deductions like mortgages, charitable bequests, and estate settlement costs. If the total net value of the estate is above the exclusion amount, any amount above the exclusion amount is subject to estate taxes.
Who Pays Estate Taxes?
Estate taxes, sometimes called the death tax, are owed by and usually paid by the estate itself rather than any inheritors. If you have an estate with a value that is above the exclusion amount, part of your estate planning should include how to pay for any estate taxes. An estate's executor will make sure that any estate subject to estate taxes files an estate tax return as part of the probate process.
Federal Estate Tax Rates
The federal estate tax rates are set by Congress, and they are subject to change with additional legislation. As of 2022, the rates are as follows:
State Estate Taxes
In addition to federal estate taxes, several states also have an estate tax. Generally speaking, the exclusion amount for state estate taxes is lower than the federal exclusion amount. So, an estate may be subject to state estate tax even if no federal estate tax is owed. For example, the estate exclusion amount for Illinois is $4 million, and the exclusion amount in Hawaii is $5.49 million. Check with your state's tax department to be aware of the estate tax laws in your state.
State Inheritance Taxes
There is not currently a federal inheritance tax, but a few states do charge an inheritance tax. An inheritance tax is paid by the inheritor rather than the estate itself, and in many cases, your relationship to the deceased will have an impact on any inheritance tax owed. For example, Iowa charges no inheritance tax for parents, children, and those on a direct line from the deceased. Brothers and sisters pay a lower rate, while aunts, uncles, cousins, and other inheritors pay a higher rate.
Estate vs. Inheritance Tax
Estate tax and inheritance tax are both taxes that relate to the estate of someone who has died, but they have a few key differences. The estate tax is paid by the estate as part of the probate process. Generally, the executor or executrix of the estate handles the payment of the estate tax before any bequests are made. There is a federal estate tax, and several states also have their own estate taxes.
An inheritance tax, on the other hand, is paid by the person who has inherited assets as part of the probate process. Usually, there is a specific exclusion amount where you can receive a small inheritance without having to pay tax (tax is charged only on the inheritance above that amount). It is typical that your relationship to the deceased person plays a factor in how much and whether you have to pay an inheritance tax. Generally speaking, the closer you were related to the deceased, the less you will have to pay in inheritance tax.
There is not currently a federal inheritance tax, but several states do have them. Maryland is currently the only state that levies both an estate tax and an inheritance tax.
How to Minimize Estate Taxes
As with most taxes, it is the goal of most people to minimize the amount of tax they are legally obligated to pay. Fortunately, there are a few strategies you can utilize to help minimize the estate taxes you would pay if you passed away. One is to realize that estate transfers to a surviving spouse are generally not subject to estate or inheritance taxes. Another is to make sure that your total estate is below the exclusion amount. The federal exclusion amount for estates is quite large, and very few estates rise above this limit. While state exclusion amounts are usually lower, it's still a minority of estates that are subject to estate tax. If you do have an estate that will be subject to estate or inheritance taxes, you might consider including an item in your will that your estate will pay for any inheritance taxes as part of the bequest.
Other strategies to minimize your estate tax include:
- Gifting: You can transfer your assets while you are alive through gifting. In 2023, a person can donate $17,000 while a couple can donate $34,000 to a non-charity recipient without incurring any taxes.
- Donating to charity: If you transfer part of your estate to charity through a charitable lead trust or a charitable remainder trust (CHR), you can lower your estate's tax liability by reducing the overall value of your estate. Of course, you also can lower your income tax liability by donating to charity.
- Moving to a different state: If you currently live in a state with an estate tax (including Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington), you could relocate to a state that doesn't have one to lower the tax liability for your loved ones.
Most estate tax planning revolves around maximizing the use of the federal and state estate tax exemptions, and ideally, good planning eliminates estate tax completely. If like most docs, your estate is worth less than the estate tax exemptions, there will be no estate tax due at all. But even if you have a very large estate, minimizing how much estate tax that will have to be paid upon your death is a worthwhile goal that will help all of your heirs after you're gone.
Have more questions about estate planning or protecting your assets? Hire a WCI-vetted professional to help you sort it out.
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