Estate Tax: Rates, Exclusions, and Impact on Gift and Inheritance Taxes

What Is an Estate Tax?

The estate tax is a federal tax levied on the transfer of the estate of a person who dies. An estate tax applies when the 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 several 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. 

How Federal Estate Taxes Work

The Internal Revenue Service (IRS) requires estates with combined gross assets and prior taxable gifts exceeding $12.06 million for 2022 and $12.92 million for 2023 to file a federal estate tax return and pay estate tax as required. For an estate worth $13 million with a 2023 exclusion limit of $12.92 million, estate taxes would be levied on $80,000 of the estate.

The unlimited marital deduction eliminates the estate tax on assets 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.

How State Estate Taxes Work

An estate that escapes federal tax may still be subject to taxation by the state in which the decedent was living at the time of their death, however, estates valued at less than $1,000,000 are not taxed in any jurisdiction.

Jurisdictions With Estate Taxes

As of 2022, these jurisdictions have estate taxes with the following threshold minimums. Connecticut has enacted legislation for its exemption to match the federal exemption in 2023.

• Connecticut ($12,920,000 for 2023 to match the federal exemption)
• 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)

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 within 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

The IRS offers generous gift exclusions. For 2022, the annual exclusion is $16,000, meaning tax filers can gift up to $16,000 to each person they wish without paying tax on any of those gifts. For the 2023 tax year, the annual exclusion increases to $17,000.

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. 

If making a gift of $37,000 in 2023 with an exclusion of $17,000, the remaining $20,000 will need to be reported on a 709 gift tax return. That $20,000 will reduce your lifetime exclusion to $12.9 million, and also your estate tax exclusion to $12.9 million.

Estate Tax and 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, select states including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania levy inheritance taxes. Maryland has both an estate and an inheritance tax.

The inheritance tax is assessed by the state in which the beneficiary is living. Whether your inheritance will be taxed, and at what rate, depends on its value, your relationship to the decedent, 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 18%, as of 2022. The exemption you receive and the rate you're charged may vary by your relationship with 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 and their threshold minimums for 2022. Iowa will abolish its inheritance taxation by 2025.

• Iowa ($25,000)
• Kentucky ($500–$1,000)
• Maryland ($50,000–$100,000)
• Nebraska ($42,500–$150,000) for 2023
• New Jersey ($0 to $25,000)
• Pennsylvania ($0 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.