Since you pay income taxes on your income throughout your lifetime, you might think that you are done with taxes after that. Unfortunately, that is not always true! Even upon your death, your assets might still be taxed again when you leave them to your heirs. In some cases, that tax rate could be over 40% when combining both a federal and state death tax. While there are exemption amounts in many cases, your heirs could be left with a hefty tax bill if you do not plan properly before your death. Keep reading below to learn all about the death tax including who pays it, how much it is, and ways that you can avoid it.
What Is The Death Tax?
The death tax is any tax levied on property and assets being transferred from the estate of a deceased person. This includes both the Federal estate tax and state inheritance taxes. A few states also levy estate taxes as well, so you could get hit with an even larger tax bill in those states. Upon your death, all the assets in your estate are added together to determine the value of your overall estate. After subtracting any exemptions, the total value of the taxable estate will be left.
The Federal government charges an estate tax that can be up to 40% of the value of the taxable estate. In addition, twelve states also charge an estate tax. These states include Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and Washington. This means that your estate must pay both a federal and state estate tax in those states. As if that were not enough, six states also impose an inheritance tax on those heirs receiving property from the estate. The states that charge an inheritance tax are Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania. The District of Columbia has repealed its inheritance tax.
How Much Are The Death Tax Rates
In most cases, the tax rate that you pay depends on the value of the decedent’s taxable estate. First, we will discuss Federal estate tax rates. The IRS is responsible for collecting these taxes. At the Federal level, the tax rates exist on a sliding scale, similar to income tax rates. The higher the value of the estate, the higher the tax rate you will pay. On the low end of the scale, the rates are 18% for taxable amounts less than $10,000. For amounts over $1 million, those funds will be taxed at a rate of 40%. This can add up quickly, so it is imperative that you account for these taxes during your estate planning process.
In addition to those Federal taxes, you might also owe state inheritance and estate taxes. These rates range anywhere from 10% to 20% depending on the size of the estate. These taxes are collected by the individual state governments. Many states allow estate tax exemptions as well as inheritance tax exemptions. These often apply when the inheritance is being left to a surviving spouse or children. Calculating the value of the estate can sometimes get tricky when the estate holds assets like real estate or even a small business. Often, professionals need to be hired to assist with putting a value on some of these assets.
Who Is Responsible For Paying Death Taxes
When it comes time to pay Federal estate taxes with the IRS, the deceased is responsible for paying his or her own estate tax with proceeds from the estate itself. The estate must file an estate tax return with the IRS per the current tax rules. In 2021, the federal estate tax exemption is $11.7 million. If the total value of the assets held in the estate, plus any prior taxable gifts, is below this value, then no federal tax will be due. Similarly, the estate must pay its own state estate taxes as well.
Inheritance tax is slightly different. The heirs themselves are responsible for paying the inheritance tax. At the state level, each heir who receives assets from the estate must claim those assets on his or her individual state tax return. Some states allow a married couple to pass assets tax-free to a surviving spouse. Often, children can also inherit assets tax-free from parents. Since most states do not charge an inheritance tax, or transfer tax, these tax laws only apply to a small portion of Americans. Keep in mind that the state inheritance tax exemptions are fairly low, so you might be responsible for paying taxes even on a small inheritance.
Difference Between Inheritance Tax And Federal Estate Tax
Many people think that inheritance taxes and estate taxes are the same thing. While these are often lumped together into what people call death taxes, these two taxes are completely separate. Estate taxes are assessed at the Federal level, although some states do also charge estate taxes. Estate taxes are paid from the estate itself and are calculated based on the overall value of the estate. Keep in mind that in 2021, only estates that are valued over $11.7 million will owe any estate taxes to the IRS. So, 99% of people in the U.S. will not have to worry about paying Federal estate taxes.
Inheritance taxes, on the other hand, are levied at the state level. There is no Federal inheritance tax. This tax is levied on each individual heir based on the value of the assets that they inherited. The rates range anywhere from 10% – 20%. The exemptions for state inheritance taxes are much lower, so many heirs will be responsible for paying this tax.
Ways To Avoid Paying Death Taxes
Most people hate paying taxes and want to learn ways to pay as little as possible. Thankfully, there are some ways that you can avoid paying death taxes or, at a minimum, at least reduce the amount that will be owed. You should always discuss your plans with an estate planning attorney, but here are a few ways that you can avoid paying these pesky taxes.
One way to avoid Federal estate taxes is by leaving your assets to a surviving spouse. In 2021, the marital deduction is unlimited, so you can pass your assets to your spouse tax-free regardless of the size of your estate. Most states also allow the tax-free transfer of property to a surviving spouse, so you might end up with a tax bill of zero going this route. Note that the spousal exemption does not apply to non-citizen spouses.
Set Up A Trust
Many people choose to set up a trust to help lower their tax bill. Creating an irrevocable trust effectively removes assets from your estate, thereby reducing the overall value of your estate. Some people choose to create intentionally defective grantor trusts or life insurance trusts. You may even choose to name the trust as the beneficiary of a retirement account like a 401k or IRA. Both of these types of trusts are effective ways to reduce the amount of estate tax that might become due.
Make Gifts During Your Lifetime
Instead of waiting to pass all your assets after your death, go ahead and begin to make gifts during your lifetime. An individual can gift assets up to $15,000 per year free of the gift tax, and a married couple can gift up to $30,000 per year. This also helps lower the overall value of your estate upon your death and reduces the amount of estate and inheritance tax that will be owed.
The Bottom Line
As the old saying goes, “Two things in life are certain – death and taxes.” With estate and inheritance tax, both of those are true. Thankfully for taxpayers, there are ways to avoid or reduce the amount of those taxes. Tax credits and other exemptions exist to help lower those tax bills. However, you should make sure that you start your planning early. Waiting too late can leave your heirs with a huge tax bill that could potentially have been avoided.
Frequently Asked Questions
Does every state impose a death tax?
No, not every state imposes a death tax. There is a Federal estate tax that applies to estates worth more than $11.7 million. Only 12 states plus the District of Columbia impose an estate tax. Six additional states also levy an inheritance tax. This means that an estate might be required to pay both federal and state estate taxes, and the heirs might also have to pay an inheritance tax.
What are some of the pros of the death tax?
One pro of the death tax is the fact that it raises a lot of money for the government. It typically raises hundreds of billions of dollars every few years. In addition, it only affects a very small percentage of Americans. Given the high exemption threshold, very few people have estates large enough to qualify for payment of the tax. More than 99% of people will not be subject to any estate taxes.
What are some of the cons of the death tax?
One con of the estate tax is the fact that the rate might be as high as 40%. In addition, most people consider this double taxation. Taxes must be paid on income and capital gains through the course of your lifetime, so taxing these same assets at death is essentially taxing the same money twice. There are also many loopholes in the tax laws that allow some wealthy people to get around the payment of many of these taxes.
What if I inherit property or assets from someone in a different state from where I live?
Typically, estate and inheritance taxes are paid based on the state in which the deceased person lived. The laws of the state in which you live do not usually matter for death tax purposes. So, even if you live in a state without an inheritance tax, you might be forced to pay one if you inherit assets from someone who lived in a state that does impose a death tax.
How is the death tax calculated?
Estate taxes are calculated based on the value of the assets in the estate minus any exemptions. Once the total taxable estate is calculated, then taxes are based on a percentage of that figure. Inheritance tax is calculated per each individual beneficiary. The amount that each beneficiary receives is used to calculate the taxes for that individual person.