The top U.S. federal estate tax rate is 40%, but most estates aren't taxed at all. In addition to the $5.45 million lifetime exclusion, there is also an annual exemption for gifts. However, your state may tax estates differently than the federal government, so your estate tax liability can vary depending on where you live.
Estate tax in the U.S.
At first glance, the U.S. federal estate tax structure looks rather complicated. There are 12 estate tax brackets, ranging from 18% for estates valued at less than $10,000 up to 40% for estates valued at $1 million or more.
However, these brackets aren't actually used in practice. There is a lifetime exemption amount, currently $5.45 million, that you can give or leave to heirs before the estate tax kicks in. This amount includes money and investments, as well as the value of property, such as houses and vehicles. It also includes taxable gifts you give while you're still alive, not just money and property you pass on after you die. For married couples, this exemption is doubled to $10.9 million. This is why most estates aren't taxed: They're simply worth less than the exemption amount.
The strange part is that the exemption is structured as a tax credit, not just a reduction in the taxable value of the estate. In other words, on an estate tax return (IRS form 706), you'll actually compute the tax on the entire estate value, but you'll receive a credit for the tax, up to the tax on a $5.45 million estate, which translates to a maximum of $2,125,800.
Because of this odd structure, any taxable portion of an estate is above $5.45 million, and therefore it's in the highest estate tax bracket of 40%. The other 11 estate tax brackets are mostly meaningless.
Annual gift exclusion
In addition to the lifetime exemption, there is an annual gift-tax exclusion of $14,000 per person. Any gifts you give of this amount or less will not count toward your lifetime exemption amount.
It's important to note that you can give a $14,000 gift each year to as many people as you like. For example, if you have three children and 10 grandchildren, you can give each of them $14,000 every year without affecting your lifetime exemption. That would be$182,000 per year in tax-exempt gifts. If you're married, then the exemption is doubled.
Will you have to pay estate tax?
Not only is $5.45 million in gifted or passed-down property tax-free, but if you use the gift exclusion correctly and for several years, then you could give away millions of dollars' worth of property or money on top of that amount.
Here's a quick calculator to help you determine how big your estate could get, based on your current assets, projected value growth rate, and liabilities. If your potential estate tax bill is more than you'd like the government to "inherit," then it might be a good idea to start taking advantage of the gift tax exclusion and other estate-planning strategies.
What about state taxes?
Finally, it's important to know whether or not your state assesses an estate tax. As of 2016, 14 states and Washington, D.C. have their own estate taxes, and not all of their lifetime exemption amounts match the $5.45 million federal threshold. For example, Oregon and Massachusetts both have exemptions of just $1 million. So it's entirely possible that you'll owe some estate taxes, even if you're exempt under federal law. Here's a thorough look at state estate taxes so you can determine whether or not they're something you'll need to worry about.