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When you’ve been paying taxes all your adult life, the idea that Uncle Sam could want a bit more after you die may be frustrating.
The truth is that most people will never have to worry about the federal estate tax — often called the “death tax.” In fact, less than 0.1% of all the people who passed away in 2018 (more than 2.8 million died in 2017, the CDC reports) are likely to be subject to the estate tax, according to a Tax Policy Center analysis of IRS data.
But whether you wind up on the receiving or giving end of a big estate, or just want to set your mind at ease regarding a smaller inheritance, understanding how the estate tax works can help.
What is the death tax?
The death tax is an informal name for the federal estate tax. The term is also sometimes used to describe inheritance or estate taxes levied by a state. The IRS says that the federal estate tax is a tax on your right to transfer property (like bank accounts, real estate or other types of assets) when you die.
“It’s the last toll on your exit from this life that the government imposes upon you,” says Mark Misselbeck, a CPA and tax principal at Massachusetts-based Katz Nannis and Solomon.
The estate tax is also closely tied to the federal gift tax, which considers any taxable gifts you make (beginning in 1977).
Most Americans probably don’t need to worry about either the federal estate or gift taxes. That’s because federal tax law allows estates to exclude a certain amount in a tax year up to a certain threshold ($11.4 million for 2019) from being subject to the estate tax.
And if the heir is a spouse, the estate they’re inheriting may not be subject to the estate tax at all. The 100% marital deduction generally allows surviving spouses to inherit without paying estate tax, no matter the size of the estate.Learn about tax deductions for married couples filing jointly
Who pays the death tax?
It’s important to understand that death taxes are paid by estates, and not by the heirs inheriting assets from the estate, because the IRS doesn’t consider inheritances to be taxable income in most cases.
But income that the deceased person (referred to as the “decedent”) had the right to receive, but which was instead received by their heir, could be subject to estate taxes and income tax for the heir. The heir might be able to claim a deduction on their own tax return for the estate tax paid on that postmortem income — however, to do that, they’d have to take the deduction in the same year they received that portion of the inheritance.
If you inherit property that later makes you money, the income you receive from that property is taxable. For example, if you inherit a rental property that later generates rental income or stocks that pay dividends, you may face a tax bill for that income.
Remember, though, that estate tax typically only applies if a person dies and their combined assets and lifetime taxable gifts are more than the threshold amount. That would require their estate to file an estate tax return and be liable for any tax obligations over that threshold.
The federal tax reform law that passed in December 2017 doubled the estate tax exemption amount from $5 million to $10 million (indexed for inflation to $11.4 million for 2019). But the increase made by the Tax Cuts and Jobs Act is temporary, applying only to tax years between Dec. 31, 2017, and Jan. 1, 2026. That means the threshold amount is set to change at the end of 2025, unless Congress acts to extend the increase or change it in some other way.
How much is the estate tax?
How much tax an estate must pay depends on several factors.
Generally, the IRS calculates the value of transferred assets, including real estate, based on the current fair market value of those assets. That may not necessarily be the same amount as the deceased person paid for the assets or their value when the deceased first acquired them.
The estate may be able to make some adjustments as well, including deductions for mortgages owed on real estate included in the estate, debt, estate administrative expenses, losses during the estate administration and more.
After you calculate the taxable portion of the estate, the applicable tax rates, ranging from 18% to 40%, are applied to the estate tax bracket the amount falls into. For example, if the taxable portion of the estate is $20,000, then you would be taxed at 18% for the first $10,000 and then 20% on the next $10,000, adding up to $3,800 in tax total.
What about the gift tax?
In addition to calculating the value of your assets when you pass away, the estate tax also considers the value of your lifetime taxable gifts. If you give someone property (including money), or allow someone to use income from your property, without expecting something of at least equal value in return, the IRS considers that a gift.
The gift tax also has an exemption or threshold amount, but it’s on an annual basis. In 2018 and 2019, for example, you can gift up to $15,000 per recipient without the amount being taxable. Other gifts are considered nontaxable and can be excluded, including the following:
- Gifts to your spouse
- Gifts to charities
- Gifts to a political organization for its use
- Tuition or medical expenses paid directly to an educational or medical institution on behalf of someone else
Any gifts beyond these exclusions count toward your lifetime taxable gifts.
Federal estate tax vs. state inheritance and estate taxes
On top of the federal estate tax, estates may also be subject to tax by the deceased person’s home state. Currently, 12 states and the District of Columbia have their own state estate tax in addition to the federal tax. But states assess estate tax in different ways.
For example, Oregon bases its estate tax on the federal taxable estate amounts and adjustments. And in addition to applying to individuals’ estates, Minnesota’s estate tax applies to estates of owners of certain types of small businesses who don’t live in the state but own real property (land) or personal property there.
The estate tax exclusion amount for each state may be lower than the federal government’s threshold. This means an estate could end up owing state-level estate tax but not federal estate tax.
And there’s inheritance tax, which is different from estate tax.
While an estate typically would be responsible for paying any estate tax that’s due, heirs are generally responsible for paying any state-level inheritance tax that may be owed. Some states, however, may exclude heirs like spouses, children or grandchildren from paying inheritance tax.
The federal government doesn’t have an inheritance tax, but six states currently do. Iowa, Kentucky, New Jersey and Pennsylvania have state-level inheritance taxes, Nebraska has county-level inheritance taxes, and Maryland has both its own estate tax and an inheritance tax.
If the idea of Uncle Sam or a state government taxing you or your loved ones just one last time rankles, don’t fret. Most inheritances are well below the threshold amount at which estate taxes begin to apply.
In fact, most inheritances are small, with about half of them coming in at less than $50,000, according to the Federal Reserve. That means most inheritances aren’t subject to federal (or state) estate tax.
But if you or a loved one has done well enough financially for estate or inheritance taxes to be a consideration, it may make sense to work with a tax professional who can help you understand the complicated process of preparing and filing the necessary tax returns.