The estate tax in the United States is a tax on your right to transfer property to other individuals upon your death, according to the IRS. In other words, when you die, the U.S. government might be entitled to a portion of your assets before the remainder can be passed to your heirs. Not all inherited assets are subject to the estate tax. In fact, the U.S. estate tax only affects the wealthiest households.
In the United States, the estate tax and gift tax are treated as a single tax system with unified limits and tax rates and are not well understood by many people. With that in mind, here's an overview of the U.S. estate tax, what assets are included, tax rates and exemptions in 2020, and more.
The lifetime exemption amount
I mentioned that the U.S. estate tax only affects the wealthiest households, and here's why.
Americans are allowed to exempt a certain amount of assets from their taxable estate. This is known as the lifetime exemption, and it changes annually to keep up with inflation and according to policy modifications.
For 2020, the lifetime exemption is set at $11.58 million. And this is a per person exemption. If you're married, you and your spouse can collectively exclude twice this amount from taxation, or $23.16 million. In other words, if you are single and die in 2020 with assets worth a total of $13 million, only $1.42 million of your estate would be taxable.
As you can probably imagine, most Americans don't have more than $11.58 million worth of assets when they die. That's why the estate tax only affects the wealthiest households in the U.S. In fact, it's estimated that fewer than 0.1% of all estates are taxable -- 99.9% of Americans don't owe any federal estate taxes at all upon their death.
The annual gift tax exclusion
It's important to mention that the lifetime exemption includes taxable gifts as well. If you give $1 million to your kids, for example, that counts toward your lifetime exemption amount, so the amount of assets that could be excluded from estate taxes would be reduced by this amount upon your death.
You don't have to pay any estate or gift tax until after your death, or until you've used up your entire lifetime exemption. However, if you give any major gifts throughout the year, you might be required to file a gift tax return with the IRS to keep track of your giving.
I say you might because there's also an annual gift exclusion that allows Americans to give as much as $15,000 in gifts each year without affecting their lifetime exemption. And there are two key points to know:
- This exclusion amount is per recipient, so you can give $15,000 to as many people as you want every year. They don't even need to be related to you. For example, you can give $15,000 each to 20 different people (a total of $300,000), and the IRS won't care.
- The exclusion is per donor. So, you and your spouse (if applicable) can give $15,000 apiece to as many people as you want. In other words, if you give $30,000 to your child to help them buy their first home and you're married, you can consider half of the gift as coming from each spouse.
As you'll see later, the annual gift exclusion is one of the most effective ways for wealthy families to reduce or even eliminate estate tax liability.
U.S. estate tax rates
The tax brackets used to calculate federal income tax are very different than the system of tax brackets that apply to taxable estates.
Technically speaking, there are 12 estate tax brackets, with tax rates ranging from 18% to 40%. However, the top estate tax bracket applies to estates with a total value of $1 million and above. Since the estate tax only applies to estates with a value of $11.58 million or more, the only tax rate that applies to taxable estates in practice is 40%.
I won't get too technical when it comes to the estate tax bracket structure and how the exemption is actually structured as a giant tax credit (my colleague Dan Caplinger published an excellent explanation of the estate tax rates, if you're interested). The important takeaway is that the estate tax rate in the United States is effectively 40% on all taxable estate assets.
How are estates valued?
Your estate is the sum of your combined gross assets minus any outstanding debts. The valuation method of your estate at the time of your death depends on the types of assets you own. In the case of cash, stocks, or other liquid assets, it's easy. The actual amount of cash is used, and it's very easy to determine the fair market value of liquid investments.
On the other hand, your estate also includes assets such as real estate, trusts, annuities, businesses you own (in whole or in part), and more. Assets like these are counted in your overall estate using their fair market value when you die, not the amount you paid for them. Obviously, some assets (such as a small business you own) can be difficult to value, so if you have any complex assets, it can take some time to compute the value of your estate.
Also, any debts (like a mortgage) are subtracted from the value of your assets, and any property that passes to a surviving spouse or to a charitable organization is not counted.
What assets are not included in your taxable estate?
I mentioned a few of these in the last section, but there are certain types of assets that are not considered to be a part of your taxable estate:
- Anything you leave to a surviving spouse. This is known as the unlimited marital deduction.
- Any amount of money or property you leave to a charity.
- Gifts you've given that are less than the annual exclusion for the year in which they were given.
- Certain types of trust assets.
Calculating estate tax: an example
Let's say that a single individual dies in 2020. At the time of their death, this person had assets with a total value of $15 million. In addition, this person had given taxable gifts (in excess of the annual exclusion allowance) of $300,000 during their lifetime.
Subtracting the 2020 lifetime exemption of $11.58 million from the total $15.3 million value of this individual's estate and taxable gifts shows a taxable amount of $3.72 million. Applying the 40% estate tax rate results in an estate tax due of $1,488,000.
Who pays estate tax in the U.S.?
First of all, estate tax is paid directly from the deceased individual's estate before assets are distributed to heirs. No tax is owed by the heirs themselves upon receiving property -- that is known as an inheritance tax, which doesn't exist in the U.S. on the federal level (although some states do have an inheritance tax -- see the list below).
Second, the estate tax only affects the wealthiest U.S. households. It's estimated that less than 0.1% of all estates owe estate tax -- that's less than one out of every 1,000.
One of the most frequent criticisms of the estate tax is that it can affect asset-rich Americans of modest incomes, such as people who own farms but don't have especially high incomes or net worth other than their primary business asset. And to be fair, this is certainly possible. If someone dies with a farm worth $20 million and few other assets, the estate tax will likely still apply to the taxable portion of their asset value.
However, this is an extremely rare case. In 2017, for example, 5,500 estates owed some amount of estate tax, but just 80 of them (about 1.5%) were cases where more than half of the estate's value was in the form of a family farm or small business. The overwhelming majority of households affected by the estate tax are truly wealthy people with sufficient liquid assets to pay the tax shortly after death.
Is the estate tax really a form of double taxation?
Another common argument in favor of repealing the estate tax is that it's a form of double taxation. In other words, if you earn a high salary your entire life, you'll have paid income tax when the money was first earned. Then when you die, the government taxes the same money again.
To be fair, this is somewhat true. However, Federal Reserve data has determined that the majority of taxable estate assets result from unrealized capital gains -- which is money that has never been taxed. For example, Warren Buffett has a net worth of about $90 billion as of January 2020. However, most of this is in the form of Berkshire Hathaway stock, which Buffett originally paid just a tiny amount for and hasn't paid any taxes on since. And although the amount of Buffett's net worth is certainly unusual, his situation isn't.
What states have estate or inheritance taxes?
It's important to emphasize that everything in this discussion so far refers to federal estate tax law. Some states have their own estate taxes, which are assessed in addition to any applicable federal estate tax.
As of early 2020, 12 states and Washington D.C. have their own estate tax:
- New York
- Rhode Island
- Washington (state)
- Washington, D.C.
Some of these states use the same lifetime exemption ($11.58 million) as the IRS, while others have their own exemptions -- and in some cases, their exemptions are much lower. If you live in one of these states and are concerned with planning your estate, it's a good idea to look into the structure and amount of your state's estate tax.
In addition, six states have an inheritance tax, which is a tax assessed on the heirs after inheriting property:
- New Jersey
Notice that Maryland appears on both lists. This means that Maryland has both an estate and inheritance tax, so if someone dies in Maryland and leaves assets to heirs who also live in the state, the same wealth can effectively be taxed twice.
Smart estate planning can help you reduce or avoid estate taxes
Obviously, wealthy individuals don't want to pay estate tax. For this reason, there's a whole subset of the financial services industry dedicated to estate planning. And while I can't possibly discuss every estate planning strategy, here are some of the most common ways Americans can reduce or even eliminate their estate tax liability:
- Give annual gifts: As we discussed, Americans can give as much as $15,000 per person to as many different people as they want in 2020. If a wealthy individual or couple starts taking advantage of this during their lifetime, it can be an effective way to shelter millions of dollars from estate tax. Let's say that you and your spouse have three children and seven grandchildren. If you both give $15,000 to each of these people every year for 10 years, that's $3 million in gifted money that won't be included in your taxable estate.
- Use a trust: This is where the estate planning industry comes in. Many wealthy Americans use strategically created trusts to reduce their eventual estate tax liability. An example is a Grantor Retained Annuity Trust (GRAT), where the estate's owner puts money (or more accurately, investments like stocks) into a trust designed to repay the estate with a small interest rate, with any gains above this interest rate coming tax-free. If you want to pursue a trust to help reduce estate taxes, I strongly advise consulting with an estate planning attorney.
- Give to charity: Any money you leave to a charitable organization is excluded from your taxable estate.
- Move: While this obviously isn't desirable or practical for everyone, keep in mind that only some states have their own estate tax. If a wealthy individual or couple moves from a state with an estate tax to one without one, it can potentially result in big savings.
To sum it up, the key takeaways on the U.S. estate tax are:
- The estate tax only affects the wealthiest 0.1% (or less) of U.S. households.
- The estate tax and gift tax operate under one unified system, with rather large lifetime and annual exclusions.
- Some states have their own estate taxes, and a handful have inheritance taxes.
- There are several effective ways for wealthy households to reduce or avoid estate taxes.
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