The estate tax is a much-hated provision of the tax laws, but many people don't realize how it actually works.
In this clip from Industry Focus: Financials, Motley Fool analyst Gaby Lapera and Dan Caplinger, the Fool's director of investment planning, examine the estate tax, including the lifetime exemption of $5.45 million that effectively restricts estate taxation to a small number of people. Yet as Dan points out, some states have lower limits, and that can leave you vulnerable to estate tax at the state level even if the IRS wouldn't think twice about collecting from you. It's important to take the estate tax into account when doing your own planning.
A full transcript follows the video.
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This podcast was recorded on Sept. 22, 2016 for the Oct. 31, 2016 episode.
Gaby Lapera: Let's move on to estate taxes. This is something that happens after you die, obviously, and your estate gets passed on to someone. I think most people have this conception that everyone gets charged an estate tax, and you're going to lose half the value of whatever gets passed on to you. That's not true at the federal level. Estate taxes only apply on the part of the estate that exceeds $5.45 million, which is, for most people, a lot of money.
Dan Caplinger: That's right. A lot of people pay a lot of attention to the 40% rate, which is very high. It's higher than any of the income tax brackets that are out there. But you're right, you have what's known as the lifetime exemption amount that covers not just what's in your state when you pass away but also taxable gifts that you make during your lifetime. You can give up to a total of $5.45 million to heirs, either during your lifetime or in your estate when you pass away, without having to pay any estate taxes at all. And that doesn't even include a lot of the exemptions that are available for estate tax. For instance, you can give an unlimited amount to your spouse, and you won't have to pay any estate taxes on that. There are other exemptions. If you make a gift of money that goes toward someone's educational expenses, as long as that gift is made directly to the educational institution, that qualifies for an exemption. There are all kinds of these exemptions that can add up. Even if you do have a large enough estate that you have to worry about that amount, there are still techniques that you can use either to reduce your estate tax or eliminate it entirely at the federal level.
Lapera: And the other thing to think about is that, although this probably won't apply to you from the federal level -- though it might -- some states have not increased their estate tax level in the same way the federal government has. Currently, there are 14 states that have estate taxes, plus D.C., and most have far lower thresholds than the federal estate tax. New Jersey is the lowest, at $675,000. But then, there's other states like Maryland and New York that currently have estate taxes thresholds that are lower than the federal government, but they're working to raise theirs until it's on par with the federal government. So, if you live in one of those 14 states, you might want to take that into account when you're crafting your post-death what-to-do documents.