Everyone knows taxes are a necessary part of life, unfortunately, they are also a necessary part of death too. Upon your death, your assets can be subjected to inheritance and estate tax (and gift tax just before your death too if you seek to avoid the prior two). The government permits residents to receive assets via gifts and inheritance following the death of a family member or close friend, but charges a fee for this privilege.
The revenue made from these taxes is important for the government. In 2020 alone, estate and gift taxes alone totaled over $17 billion. Given the certainty of these taxes for the majority (namely inheritance tax, since only a small number must pay estate or gift taxes), it is vital that people understand them so that they can pay the minimal amount they are required.
This article explores who has to pay these taxes, and the types of assets that they are liable to be paid upon.
What Is It?
The US does not charge federal Inheritance tax, it is merely a state levy that is only charged in six states – Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The tax is imposed on the beneficiaries of the estate of a deceased person. on the state in which the decedent lived or owned property, the value of the inheritance, and the beneficiary’s relationship to the decedent.
Inheritance tax is separate from estate tax; the latter is assessed based on the value of the decedent’s estate before its assets are dispensed, whereas inheritance tax is levied against individual beneficiaries to an estate upon receipt of the assets they have been assigned.
How Is It Calculated?
Only sums exceeding a specific amount will be subjected to inheritance tax; beyond each state’s threshold, the exact amount will be calculated on a sliding basis. The proportion paid in inheritance tax will usually start off below 10%, before rising to between 15-20%. The two factors influencing the are the value of the assets inherited and the beneficiary’s relationship to the deceased.
The latter of these two factors plays a much larger role in determining the quantity of inheritance tax that will be levied. As a general rule, if the beneficiary has a closer tie to the decedent, they have a higher exemption amount and are not expected to pay as high a proportion of inheritance tax.
As an example, spouses will always be exempt from inheritance tax, and the same is often true for close family such as children and parents. In four of the six states, descendants pay no inheritance tax. For the extended family (such as siblings or grandparents), if they are even liable to pay this tax, will be offered far more favorable terms.
Estate Tax v Inheritance Tax
Estate tax is very similar to inheritance tax, except it is applied on a federal scale and against the estate rather than the beneficiary. A decedent’s estate refers to the sum of all the assets they own or had a financial interest in when they died (e.g. stocks, property and jewelry). If the value of the decedent’s estate is in excess of $11.7 million, then a federal estate tax return must be filed by the estate’s executor.
In simple terms, this means that any value that exceeds the exemption amount of $11.7 million will have a 40% rate of taxation applied to it; this value that is greater than the exception cap is referred to as the taxable estate. The reason this works is because the decedent and their estate are considered to be two distinct taxable entities.
How Is It Calculated?
The value of the decedent’s estate is calculated by aggregating all the assets and property they owned (including their shares of jointly owned assets) and sometimes life insurance. The worth of each asset contained within the estate is measured at a ‘fair-market rate’ at the time of the owner’s death.
Next, to calculate the value of the ‘taxable estate’ certain specific transactions are subtracted from the estate’s total value. This includes all transfers to the decedent’s spouse, donations to charities, debts, and the cost of organizing the funeral and estate.
Decedents can transfer sums of any amount over the exemption limit to their surviving spouse in order to lower the value of their estate below the threshold and thus avoid this taxation. This means that married couples essentially have an exemption limit of $23.4 million if they manage their estates well.
Gift tax is one of the government’s instruments to reduce the amount of taxation lost from estate tax. One way of subverting inheritance tax is for an estate owner to transfer a gift of money to your children/grandchildren before the amount can be taxed after your death. Gift tax precludes the same subversion from being able to apply to estate tax.
Any transfers of property that take place for less than the value of the asset’s full ‘market value’ require a gift tax return to be filed, and any gift tax liability paid by April 15 the next year to be paid upon receipt of the asset. This only applies for gifts above the annual exclusion amount of $15,000 per recipient from each donor (or $30,000 per recipient from married couples), anything below these thresholds is not taxable.
As it is intended to prevent people from escaping estate tax, the tax rate structure of gift tax is identical to that of estate tax, as are the exemption amounts. Estate owners are free to transfer as many gifts as they please during a year, but once the gross value of all these gifts exceeds the per-recipient exclusion threshold, they must pay gift taxes.
Changes To Estate and Gift Taxes
Following the 2017 Public Law 115-97 tax act, the exemption amount for estate tax liability was doubled until the end of 2025. Following this period, the exemption amount is expected by many to fall to as little as $6 million.
Therefore, for those looking to tax advantage of gifts to avoid estate tax, they should be wary that doing it would be optimal to do so earlier rather than later while they can still keep the tax benefit of the higher exemption amount.
Whilst a lot of information to take in, the fundamental concepts surrounding these three types of taxation are quite simple to understand when presented with a comprehensive overview. For more information on this topic, please see this suggested resource.