Estate tax — a tax levied on an heir's inherited portion of an estate — is a subject most people aren’t familiar with until they have to deal with it directly. No one wants to think about the possibility of losing a loved one, but being prepared for the tax burden of inheritance can make the grieving process smoother and simpler.
Read on for information on estate taxes and who has to pay it. (For related reading, see: Who Should Be Your Life Insurance Beneficiary?)
Estate Tax 101
There are three types of taxes you can pay: income tax, inheritance tax and estate tax. Estate tax is levied on what you pass on after your death. These items can include cash, retirement accounts, property and more. Currently, you don’t have to pay federal estate tax if the estate is less than $5.45 million for 2016.
However, there are quite a few states that have their own estate tax. These include Connecticut, Delaware, District of Columbia, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Oregon, Rhode Island, Tennessee, Vermont and Washington. To be liable for a state’s estate tax, the estate or the person to whom it belonged must have been a resident of that state. The residence of the beneficiary is not taken into account.
Like the federal estate tax, the value of the estate must be over a certain amount in order for taxes to be owed. Each state has its own exemption and the amounts vary widely, from $675,000 to $5.43 million. The amount is determined by its fair market value, not what the deceased paid for them. For example, if a house was bought at $5 million but its current market value is $4 million, the latter amount will be used.
Anything going to a surviving spouse or eligible charity is not counted in the total amount. Other deductions, including any debts or fees that come with the estate are also not included in the final calculation. Like income tax, the estate tax rate is only used on the amount that surpasses the exemption. So if your estate was valued at $6 million, you’d only have to pay taxes on $570,000 — not the full amount. (For related reading, see: What Are the Keys to Setting Up a Trust Fund.)
Estate tax should be avoided if possible, because the rate is so much higher than income tax. Current estate tax rates are at 40%.
Who Doesn’t Have to Pay?
A spouse doesn’t have to pay estate tax on what’s left to them. This is true no matter the value, so even a widow receiving a multi-million dollar estate will be free of any tax liability.
Charities that receive money or other assets from an estate also don’t have to pay an estate tax. This is a common avenue for tax fraud, and the IRS is very particular about ensuring the legitimacy of any charity being gifted an inheritance, especially in the case of a particularly large estate.
Unfortunately, this list is very small. Anyone who falls outside of these two categories has to pay estate tax.
The Bottom Line
Inheritance taxes can be tricky, and most people have to deal with them for the first time during a very inconvenient period of their lives. It's better to learn now, familiarize yourself with the laws and be prepared to deal with the inevitable. The laws surrounding estate tax change constantly, so make sure to stay updated. Some states are phasing out their estate tax, while others are changing the exemption amount. If you’re worried about your own inheritance, you can help prepare your loved ones for taxes by explaining the laws to them. You can even set aside a fund to help offset that tax burden when it comes. You can also meet with a lawyer, CPA or CFP to start planning your estate and minimizing the amount of taxes your beneficiaries will have to pay. (For related reading, see: How Are Trust Fund Earnings Taxed?)