This article was updated on May 5, 2016.
The federal estate tax, also known as the death tax, is assessed on money and property you pass on to your loved ones after you die. The tax rates on estates are among the highest in the U.S. tax code, with a maximum rate of 40%, but it may not be as "taxing" on you as it seems thanks to a big exemption amount. Here's what you need to know about the 2016 estate tax rates and how they could affect you and your family's inheritance.
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The 2016 estate tax rates
For 2016, the estate tax rates remain unchanged. The formula for computing estate taxes is rather complicated -- there are 12 different estate tax "brackets", ranging from 18% to 40%. Here are the current rates and the estate sizes they apply to.
|
For Taxable Estates Between ... |
And ... |
You'll Pay This Amount of Tax ... |
Plus, You'll Pay This Percentage on the Amount in Excess of the Lower Limit |
|---|---|---|---|
|
$0 |
$10,000 |
$0 |
18% |
|
$10,000 |
$20,000 |
$1,800 |
20% |
|
$20,000 |
$40,000 |
$3,800 |
22% |
|
$40,000 |
$60,000 |
$8,200 |
24% |
|
$60,000 |
$80,000 |
$13,000 |
26% |
|
$80,000 |
$100,000 |
$18,200 |
28% |
|
$100,000 |
$150,000 |
$23,800 |
30% |
|
$150,000 |
$250,000 |
$38,800 |
32% |
|
$250,000 |
$500,000 |
$70,800 |
34% |
|
$500,000 |
$750,000 |
$155,800 |
37% |
|
$750,000 |
$1,000,000 |
$248,300 |
39% |
|
$1,000,000 |
----------- |
$345,800 |
40% |
Source: IRS.
According to this chart, if you leave a taxable estate of $400,000 to your heirs in 2016, they'll owe $70,800 plus 34% of $150,000, for a total of $121,800. However, as we'll see shortly, these "brackets" aren't really useful when computing the estate tax.
The rates are high, but most estates aren't taxed at all
The estate tax rates in the chart only tell part of the story. There is also a lifetime exemption -- that is, an amount you can give your heirs that is excluded from taxation.
This lifetime exclusion amount is one aspect of estate taxation that has changed for 2016, up by $20,000 to $5.45 million. Note that this includes property you leave your heirs as well as cash, so items such as houses count toward the exclusion. It also includes taxable gifts you give while you're alive, not just the possessions you pass on after you die.
Here's the strange part. The exemption is structured as a "unified credit", as opposed to a simple reduction in the taxable value of the estate. In other words, when filing an estate tax return (IRS form 706), you'll compute the estate tax on your entire estate, and then receive a credit for what the tax would be on a $5.45 million estate: $2,125,800. Because of this, any taxable portion of an estate is taxed at the top 40% rate, rendering the other 11 brackets in the chart above meaningless for everything except calculating the credit amount.
For example, if you leave a $10 million estate, your heirs will face an tentative estate tax of $3,945,800, according to the chart. Subtracting the $2,125,800 credit shows an net estate tax of $1,820,000, or 40% of the amount by which $10 million exceeds the exclusion amount. Of course, once you know how it works, you can simply calculate 40% of the estates' value above the exclusion.
As you can probably imagine, most Americans' estates are worth significantly less than $5.45 million, so the estate tax doesn't affect the majority of people.
Plus, there's an annual exemption
In addition to the lifetime exclusion amount, there is also an annual gift-tax exemption, which is $14,000 per person. For those fortunate enough to have estates valued above the lifetime exclusion, the annual gift exemption can be a useful tool for estate planning.
Note that you can give a $14,000 gift every year to as many people as you'd like. If you have three children, their three spouses, and 10 grandchildren, you can give each person $14,000, for a total of $224,000 per year that doesn't count toward your lifetime exclusion. Plus, if you're married, you can give $28,000 per person – a gift from yourself and another from your spouse. If you plan ahead and start distributing your estate for years before you pass away, you can literally give millions to your heirs, 100% tax-free.
The Foolish bottom line
While the 2016 estate tax rates are rather high, most Americans will never have to worry about them. And the effective tax rate for estates valued at more than the exclusion amount can be significantly lower.
Let's say that when you die, you leave an estate valued at $7,000,000 to your heirs. Well, since the first $5,450,000 is excluded, only $1,550,000 will be subject to estate taxation. At the 40% estate tax rate I explained earlier, this results in a tax liability of $620,000 – an effective tax rate of less than 9% on your $7 million estate. Keep in mind that it could be even lower if you had taken advantage of the annual gift tax exemption along the way.
In a nutshell, the 2016 estate tax rates may look a bit steep at first glance, but they may not affect you as much as you think. The lifetime exclusion, combined with some smart estate planning, can minimize the impact of the estate tax on you and your loved ones.
