As the old saying goes, nothing is certain except death and taxes. Nobody really likes either one of these things – and when you put the two together, people hate the combination even more.
The best example of this is the federal estate tax. According to the nonpartisan Center for Budget and Policy Priorities (CBPP), this tax raises about $246 billion for the Federal Government every year. Many politicians argue that this “death tax” should be reduced or even repealed completely – and many Americans seem to agree. For example, when NJ.com posed the question, “Should the estate tax be repealed?” to readers, 53% of them said yes.
However, the federal estate tax is only part of the picture. Several states have their own estate taxes, and others have slightly different inheritance taxes. On top of that, the federal tax doesn’t just cover the money you leave to your heirs when you die – it also includes “gift tax” on large sums of money you give away during your lifetime.
Here’s a closer look at how estate and inheritance taxes work. It won’t make either death or taxes go away, but it can help you plan better ways to deal with them.
The Federal Estate Tax
When politicians refer to the estate tax, they’re usually talking about the federal estate tax. When a person dies and leaves a substantial amount of wealth behind, the Federal Government takes a portion of that wealth as a tax before it’s distributed to heirs. Many people say this is unfair because the person already paid taxes on that money when it was first earned, so it shouldn’t be taxed a second time when the person dies.
However, it’s important to understand that the overwhelming majority of people never have to pay the federal estate tax. According to the CBPP, only 2 out of every 1,000 Americans have any tax collected from their estates. A person who dies in 2016 can leave up to $5.45 million in assets before the government touches a penny of it. Moreover, for married couples, this amount doubles, so a couple can leave up to $10.86 million to their heirs tax-free.
Gift Taxes and the Unified Credit
At first glance, it looks like it should be pretty easy to avoid paying the estate tax, no matter how much money you have. All you would have to do is give away your money to your intended heirs while you’re still alive. As long as you gave away enough to reduce the value of your estate to $5.45 million or less, it wouldn’t be taxed.
However, the government has already thought of that loophole. To close it, the Internal Revenue Service charges a 40% “gift tax” on any large sums you give away during your lifetime. That includes not only cash, but also items with a large cash value, such as jewelry and cars. Under IRS rules, you can only give away $14,000, as of 2016, worth of gifts to any person in a given year without paying the gift tax.
When you make a gift that’s higher than that amount, you have a choice: You can either pay the gift tax right away, or count the gift against your “unified credit.” This is the total amount of your wealth you can exempt from the estate tax – both during your life and after your death. Using this credit, you can give away up to $5.45 million during your life without paying tax – but if you do use the entire amount, all of your estate becomes subject to taxation after your death. Moreover, the unified credit or the amount exempted from estate tax can change – though it’s $5.45 million in 2016, it could be more or less than that amount in the future.
Although most gifts greater than $14,000 are subject to either the gift tax or the unified credit, there are a few exceptions, including the following:
- Gifts to Your Spouse. If you give your spouse a large gift, such as a new car worth $30,000, you pay no gift tax. You also don’t have to count the $30,000 against your unified credit. You could even give your spouse a $30,000 car every single year for 30 years, for a total of $900,000, and it wouldn’t affect your estate tax liability.
- Tuition Payments. College tuition is very expensive these days, and a year’s tuition can easily add up to well over $14,000. Fortunately, you can pay tuition bills for your children – or anyone else, for that matter – without having to pay taxes on them. No matter how many children you are putting through school at once, the money you pay for it isn’t taxable. However, the payment must be made directly to the school, not to the student.
- Medical Bills. Healthcare costs can also add up to many thousands of dollars. If a friend or relative needs an expensive medical procedure that isn’t covered by health insurance, you can offer to pick up the tab without having to pay gift tax. Here, again, the payment must be made directly to the medical facility.
- Charitable and Political Donations. Money donated to a tax-exempt charity is never treated as a taxable gift. In fact, you can actually deduct these donations on your income taxes, rather than paying any additional tax on them. Money you give to political organizations also isn’t subject to gift tax, but you don’t get a deduction for it.
Your Gross Estate
To figure out how much your estate is worth, the IRS starts by calculating your gross estate. This means everything you own at the time of your death: cash, investments, business interests, and property.
If your estate includes items such as furniture, jewelry, or paintings, the IRS calculates their “fair market value,” meaning the amount you could get for selling them. So if you bought a living room set for $3,000 ten years ago, but it’s now worn out and worth only $500, that’s how much value it adds to your gross estate. On the other hand, if you bought a painting for $1,000 and it has increased in value to $2,000, it adds that amount to your gross estate.
If you are married, then property owned entirely by your spouse is not considered to be part of your gross estate. Gifts you’ve given during your life that are now completely in someone else’s hands also aren’t counted. However, if the gifts were taxable, they count toward your $5.45 million unified credit.
Your Taxable Estate
After figuring out your gross estate, the IRS starts taking off deductions that reduce the amount of tax that’s due on it. These include:
- The marital deduction for money or property that you leave directly to your spouse.
- The charitable deduction for money you leave to a tax-exempt charity.
- Mortgages and other debts that you owe, which get paid before your estate is taxed.
- The administration costs of your estate.
- Any losses during the estate administration process, such as a stock that declines in value between the time you die and the time the final estate tax is calculated.
After taking off all these deductions, there’s one more step left. The IRS adds back in the value of all the taxable gifts you’ve made in your lifetime – that is, gifts greater than $14,000 per year on which you paid the gift tax. The resulting sum is your taxable estate – the figure the IRS uses to calculate how much estate tax it should collect.
Calculating the Estate Tax
Finding your taxable estate still isn’t the final step in the process. Before actually calculating the estate tax that’s due, the IRS has to subtract the unified credit – the $5.45 million you’re allowed to give away, tax-free, both before and after your death.
To figure out how much unified credit you have, the IRS starts with the maximum $5.45 million. Then it deducts the value of any gifts you’ve made in your lifetime without paying gift tax. So, for example, if you’ve made $1 million in lifetime gifts, you have $4.45 million worth of universal credit left. If your taxable estate comes to less than that, there’s no estate tax at all.
In fact, if you were married, your estate can take whatever part of your unified credit you have remaining and pass it along to your surviving spouse. Suppose, for instance, that your taxable estate is $4 million, and you haven’t used up any of your $5.45 million unified credit. That means your widow or widower can take the extra $1.45 million and add it to his or her unified credit. He or she can now leave an estate of up to $6.90 million without owing any estate tax.
If your taxable estate is more than your unified credit balance, then the excess is subject to tax. For instance, if your taxable estate is $7 million, then after the $5.45 million credit, $1.55 million is taxable. This entire sum is taxed a flat rate, which is currently set at 40%. That means the Federal Government gets to collect $620,000 in taxes, leaving a total of $6.38 million for your heirs.
However, there’s still one more twist. Any gift tax you’ve already paid during your life gets credited against the tax that’s due on your estate after death. So, for instance, if you made $2 million in taxable gifts, you would have paid $800,000 in gift tax. That’s more than enough to wipe out the $620,000 in estate tax, leaving the entire $7 million for your heirs to enjoy.
State Taxes On Inheritance
If you’re like most Americans, your heirs will never have to worry about dealing with the federal estate tax. However, that doesn’t mean they won’t have to pay any taxes on the money they inherit from you. Several states also charge their own taxes on money that’s passed along after death.
These state taxes fall into two types: estate taxes and inheritance taxes. According to the Tax Foundation, 15 U.S. states and the District of Columbia currently have estate taxes, and six states have inheritance taxes. Two states – Maryland and New Jersey – charge both kinds of tax.
State Estate Taxes
Just like the federal estate tax, state estate taxes get skimmed off the top of your estate before the money passes on to your heirs. Also, just like the federal estate tax, they have an exemption – a certain amount of money that doesn’t count toward the taxable estate.
However, unlike the federal estate tax, most state estate taxes aren’t a simple flat rate. Instead, the states use a progressive tax, taking a larger cut off of estates that are worth more. In most states, the estate tax ranges from 0.8% to 16%. The highest estate tax is in the State of Washington, where it ranges from 10% to 20%.
Exemption amounts also vary from state to state. The lowest exemption rate is in New Jersey, where all estates over $675,000 must pay estate tax. By contrast, in Delaware and Hawaii, the exemption rate is $5.45 million – the same as the rate for the federal estate tax.
The 14 states that currently have estate taxes are:
- New Jersey
- New York
- Rhode Island
- Tennessee (eliminated in 2016)
State Inheritance Taxes
An inheritance is a tax that your heirs pay on the money they inherit from you. Instead of being charged as a lump sum against your estate, it’s paid separately by each heir on the money they inherit.
However, the amount your heirs have to pay depends on their relationship to you. For instance, in most states with an inheritance tax, any money you leave to your spouse is exempt. In some cases, other near relatives are also free from inheritance tax or pay tax at a reduced rate.
The six states with inheritance taxes are
- New Jersey
Some of these states charge a flat rate on all inheritances; others use a progressive tax. The highest inheritance tax is in Nebraska, where non-relatives pay 18% on wealth they inherit. The 2015 Facts and Figures report published by the Tax Foundation has details about how different states calculate their inheritance and estate taxes.
In most cases, estate taxes and inheritance taxes only affect people with a lot of money to leave. Only 0.02% of all taxpayers get hit by the federal estate tax, and the tax software provider TurboTax estimates that only 2% face estate taxes in the states where they lived.
However, if you want to make sure you keep the tax burden as low as possible for your heirs, there are several things you can do ahead of time:
- Make Smaller Gifts Regularly. Because of the gift tax and the unified credit, you can’t get around the federal estate tax by giving all your money away in big lump sums. However, you can give smaller gifts – up to $14,000 per year – to your heirs throughout your lifetime. For instance, if you have three children, and you give each one of them $14,000 every year for 10 years, you’ll gradually whittle down the size of your gross estate by a total of $420,000. If you don’t want to hand your children $14,000, open an investment account with M1 Finance and invest the money in their name. It will make a little more difficult for them to spend it on a new car or vacation.
- Do the Math on Bigger Gifts. If you choose to give gifts over the $14,000 limit, you have to decide whether to pay the gift tax at the time or charge them against your universal credit. Which choice results in a smaller total tax burden depends on how big you expect your estate to be when you die – something that’s hard to predict ahead of time. So before making a gift this size, consult with an accountant. They can help you crunch the numbers and decide which tax choice is most likely to be better.
- Give to Charity. Whether you give to charities during your lifetime or leave them money in your will, the donation isn’t taxable. So doing either – or both – is a good way to reduce the size of your estate and support a worthy cause at the same time. If you had $10 million in assets at the time of your death, leaving half that money to charity would reduce the size of your estate to $5 million – low enough to avoid the federal estate tax completely.
- Share With Your Spouse. Any money you leave to your spouse isn’t subject to the federal estate tax. So if you have a $10 million estate and leave all of it to your spouse, you can avoid the federal estate tax completely – and most state inheritance and estate taxes as well. As a bonus, your entire $5.45 million unified credit can be rolled over to your spouse’s estate, so he or she can leave a larger sum to his or her heirs tax-free.
- Check Your State Laws. Not every state has an inheritance or estate tax, and those that do all have different rules about how they’re applied. So to plan your estate around state taxes, start by consulting the Tax Foundation to see what the laws are in the state where you live. Then talk to an accountant or estate planner about planning your estate to reduce the tax burden for your heirs.
One thing that’s often overlooked in all the furor over the estate tax is that it’s an important source of revenue for the government. The money it raises, like all other taxes, goes to support useful projects that Americans depend on, from the armed forces, to Interstate highways, to food aid for people in need. So getting rid of the tax completely would either take $246 billion away from these important projects, or tack it on to the ever-growing budget deficit. Compared with these choices, maybe skimming a little bit of money off the estates of multimillionaires isn’t such a bad option.
Now that you know the facts about the estate tax, how do you feel about it? Do you think it’s fair or unfair?