Estate Tax

What Is an Estate Tax?

An estate tax is a levy on estates whose value exceeds an exclusion limit set by law. Only the amount that exceeds that minimum threshold is subject to tax. Assessed by the federal government and a number of state governments, these levies are calculated based on the estate's fair market value (FMV) rather than what the deceased originally paid for its assets. The tax is levied by the state in which the deceased person was living at the time of their death. 

Key Takeaways

  • The estate tax is a financial levy on an estate based on the current value of its assets. 
  • Federal estate taxes are levied on assets in excess of $11.7 million for 2021 and $12.06 million for 2022.
  • Nearly one in four states have their estate taxes, with lower limits.
  • Assets transferred to spouses are exempt from estate tax.
  • Recipients of an estate's assets may be subject to inheritance tax, again above certain limits.

How Federal Estate Taxes Work

Under what is known as the unlimited marital deduction, the estate tax does not apply to assets that will be transferred to a surviving spouse. However, when the surviving spouse who inherited an estate dies, the beneficiaries may owe estate taxes if the estate exceeds the exclusion limit.

The Internal Revenue Service (IRS) requires estates with combined gross assets and prior taxable gifts exceeding $11.7 million (for 2021) and $12.06 million (for 2022) to file a federal estate tax return and pay estate tax as required.

In many instances, the effective U.S. estate tax rate is substantially lower than the top federal statutory rate of 37%. This discrepancy happens partly because the tax is assessed only on the portion of an estate that exceeds the exclusion limit.

To illustrate the impact of the exclusions, consider an estate that's worth $13 million. With the 2022 exclusion limit of $12.06 million, federal estate taxes would be owed on $940,000 of the estate or less than a tenth of its total assets. In 2022, the rate is 40%, so that tax bill will be $376,000.

In addition, estate holders and beneficiaries, or their attorneys, continually find new and creative ways to protect significant chunks of an estate's remaining value from taxes by taking advantage of discounts, deductions, and other legal strategies.

How State Estate Taxes Work

An estate that escapes federal tax may still be subject to taxation by the state where the deceased person was living at the time of their death. That's because the exemptions for state and district estate taxes are only a fraction of those of the federal exclusion. That said, estates valued at less than $1,000,000 are not taxed in any jurisdiction.

Jurisdictions With Estate Taxes

Here are the jurisdictions that have estate taxes, with the threshold minimums at which they apply shown in parentheses.

  • Connecticut ($9,100,000)
  • District of Columbia ($4,254,800)
  • Hawaii ($5,490,000)
  • Illinois ($4,000,000)
  • Maine ($6,010,000)
  • Maryland ($5,000,000)
  • Massachusetts ($1,000,000)
  • Minnesota ($3,000,000)
  • New York ($6,110,000)
  • Oregon ($1,000,000)
  • Rhode Island ($1,648,611)
  • Vermont ($5,000,000)
  • Washington State ($2,193,000)

Above those thresholds, the tax is usually assessed on a sliding basis, much like the brackets for income tax. In 2021, the tax rate is typically 18% or so for amounts just over the threshold and rises in steps, usually to 39%. Some states, such as Massachusetts, offer tax rates as low as 0% depending on the taxable size of the estate.

The Relationship Between Estate Tax and Gift Tax

Since estate taxes are levied on an individual's assets and estate after death, they can be avoided if you gift assets before you die. However, the federal gift tax applies to assets that are given away in excess of certain limits while the taxpayer is living. According to the IRS, the gift tax applies whether the donor meant the transfer as a gift or not.

Gift Tax Exclusion

However, the IRS offers generous gift exclusions. For 2021, the annual exclusion is $15,000, meaning tax filers can give up to $15,000 to each person they wish without paying tax on any of those gifts. For the 2022 tax year, the annual exclusion is $16,000.

And they may offer gifts up to the value of the gift exclusion year after year without incurring tax. These provisions make gifting an effective way to avoid tax on assets transferred to people, such as non-family members, who might be subject to the estate tax if the assets were transferred as part of an estate.

Gift Exclusion Limit

If your gifts exceed the gift-exclusion limit, they aren't subject to tax immediately—and may never be taxed unless your estate is substantial. The amount above the gift limit is noted and added to the taxable value of your estate when calculating estate tax after you die. 

For example, let's say you decide to make a gift of $76,000 in 2022. Since the annual exclusion is $16,000, you'll be spared tax up to that number. The remaining $60,000, however, will need to be reported on a 709 gift tax return. That $60,000 will reduce your lifetime exclusion to $12M, and also your estate tax exclusion to $12M.

The estate tax is sometimes referred to pejoratively as a "death tax" since it is levied on the assets of a deceased individual.

Estate Tax vs. Inheritance Tax

An estate tax is applied to an estate before the assets are given to beneficiaries. In contrast, an inheritance tax applies to assets after they have been inherited and are paid by the inheritor.

How an Inheritance Tax Works

There is no federal inheritance tax, however, and only select states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) still have their own inheritance taxes. Maryland alone has both an estate and an inheritance tax.

The inheritance tax is assessed by the state in which the inheritor is living. Whether your inheritance will be taxed, and at what rate, depends on its value, your relationship to the person who passed away, and the prevailing rules and rates where you live.

As with estate tax, an inheritance tax, if due, is applied only to the sum that exceeds the exemption. Above those thresholds, the tax is usually assessed on a sliding basis. Rates typically begin in the single digits and rise to between 15% and 19%. The exemption you receive and the rate you're charged may vary by your relationship to the deceased.

Inheritance Tax Exceptions

Life insurance payable to a named beneficiary is not typically subject to an inheritance tax, although life insurance payable to the deceased person or their estate is usually subject to an estate tax.

As a rule, the closer your relationship to the decedent, the lower the rate you'll pay. Surviving spouses are exempt from inheritance tax in all six states. Domestic partners, too, are exempt in New Jersey. Descendants pay no inheritance tax except in Nebraska and Pennsylvania.

Jurisdictions With Inheritance Tax

Here are the jurisdictions that have inheritance taxes, with their threshold minimums shown in parentheses.

  • Iowa ($25,000)
  • Kentucky ($500–$1,000)
  • Maryland ($50,000–$100,000)
  • Nebraska ($10,000–$40,000)
  • New Jersey (None to $25,000)
  • Pennsylvania (None to $3,500)

Because the rates for estate tax can be quite high, careful estate planning is advisable for individuals who have estates worth millions of dollars that they want to leave to heirs or other beneficiaries.

Article Sources
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