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Estate Tax: What Is It And Who Has To Pay?

Sarah Li Cain4-minute read

When someone passes away, their assets or estate are subject to taxation, known as estate tax. Most estates don’t pay both federal and state estate taxes – in most cases, taxes are only levied if the deceased’s assets are worth at least $11.58 million.

In any case, it’s good to understand what rights you and your heirs have so nobody encounters any expensive surprises.

What Is The Federal Estate Tax?

When a taxpayer dies, a tax is collected once that person’s assets are transferred to their beneficiaries or heirs. Also known as the death tax, the federal government calculates the estate tax by applying the exemptions offered when utilizing the various credits and deductions available.

In 2017, the Tax Cuts and Jobs Act increased estate tax exemption gradually from 2018 to 2025. It factored in inflation, meaning the exemption is set to reach $11.18 million (and twice that for married couples) in 2020.

If someone needs to pay estate tax, it only applies to the amount that exceeds the exception amount. For example, if you inherit $12 million, only $820,000 would be subject to estate tax. Tax rates for taxable portions of any estate start at 18% and max out at 40%.

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Are There Estate Taxes At The State Level?

While the majority of taxpayers tend to be exempt from federal estate tax, there are a few states like Hawaii and Maine that assess state estate taxes. However, their exemptions tend to be lower compared to the federal level.

Since laws in every state may differ, it’s best to check what the laws are in your area. In addition, speaking with an experienced estate planning attorney in your state is a good idea so you can create a plan to minimize taxes overall.

How Does The Estate Tax Work?

For couples, the first spouse who dies will leave the entire estate to the surviving spouse tax-free. The surviving spouse can then claim the entire $22.36 million exemption. The majority of U.S. taxpayers never pay estate taxes. Taxpayers can use the estate valuation method to determine how it works.

For example, your spouse has assets worth $2.5 million and he passes away in a car accident. He leaves the entire estate to you. You won’t need to pay any estate taxes because the assets are way below the exemption, plus you don’t live in a state that requires you to pay state estate taxes.

What Is Estate Planning?

Estate planning is a process by which someone makes a plan on who will manage and distribute their assets after their death. It involves figuring out how to settle or minimize estate taxes and distribute assets and who will care for minor children. While you can do it yourself, professionals such as attorneys, accountants and financial planners experienced in estate law can help you reduce your tax burden using some basic strategies.

Gifting To Heirs During Life

One of the best ways to avoid estate tax would be to give away parts of your estate before your death so that your estate is smaller after you’ve passed. The IRS allows individuals to give up to $15,000 as a gift per recipient. Spouses can also give gifts up to that amount. That being said, rules around gift-giving can be complicated, so check with a tax professional before doing anything.

Creating A Trust

Trusts are a popular way to divide and handle assets in estate planning. In essence, they’re an entity created by law that owns assets housed within it. These assets are then handled and administered by a trustee, whom you can designate.

One reason to create a trust is to protect a beneficiary who is too young or is unable to manage finances – for example, you pass away before your children reach the age of majority (adulthood as recognized by law). Other reasons include avoiding probate and shielding assets from taxes.

Charitable Giving

You can give a charitable gift in any amount without incurring a gift tax. In other words, your donations can be made tax-free after you die. If you’re interested in leaving a legacy in regard to your philanthropic work, you can consider donating to reputable charities when you pass so that it can reduce the amount of your taxable estate.

Estate planning professionals can help you create a plan that includes charitable giving.

How Is The Estate Tax Paid?

An estate is automatically created when someone dies. Your executor — someone who is tasked with handling your estate — is officially named upon your passing. You can choose who it is in your estate planning documents. The executor will look at your estate planning documents and do their best to adhere to the instructions provided.

Furthermore, the estate must file a tax return with any taxes due within 9 months of your passing. There is a possibility of receiving a 6-month extension if you request it a month before the deadline. As long as there is unfinished business in the estate, the estate will continue to be intact.

Estate Tax FAQs

Are Estate Tax And Inheritance Tax The Same Thing?

The term death tax tends to lump together both estate and inheritance tax when, in fact, there are differences. Estate tax refers to the amount paid when an estate is transferred, and inheritance tax is the amount paid by the beneficiary when they inherit the estate.

Only Iowa, Kentucky, Maryland, Nebraska, New Jersey and Pennsylvania collect inheritance taxes.

What Is The Unlimited Marital Deduction?

Regardless of the size of the estate, a spouse who dies can leave it to the surviving spouse without it being considered a taxable event. The surviving spouse will only pay tax on income received each year on their federal and state income taxes.

Who Can Be A Trustee?

Any adult can be designated a trustee by the person who owns the assets. This means it can be a family member or close friend, or a paid professional, like an attorney or accountant.

How Do I Know If I Can Trust The Trustee?

It can be difficult to designate a trustee – even if you trust them, it’s impossible to predict what many would do in the role. That being said, trustees are bound to legal requirements, the most important one being the fiduciary duty. This means the trustee needs to act in the best interest of the trust, meaning they can’t engage in actions only beneficial to themselves or what they want to do.

Summary: Estate Taxes Affect Only A Few Taxpayers

Although you may not need to pay estate taxes, it’s good to know how they work. And, it’s a good idea to learn more about managing your personal finances so that you and your loved ones are taken care of, no matter what stage of life you’re in.

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    Sarah Li Cain

    Sarah Li Cain is a freelance personal finance, credit and real estate writer who works with Fintech startups and Fortune 500 financial services companies to educate consumers through her writing. She’s also a candidate for the Accredited Financial Counselor designation and the host of Beyond The Dollar, where she and her guests have deep and honest conversations on how money affects our well-being.