Estate Tax Definition

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Estate Tax Definition

What Is an Estate Tax?

An estate tax is a charge levied on estates whose worth exceeds a statutory exclusion limit. Only the amount that exceeds the minimal threshold gets taxed. These taxes are assessed by the federal government and many state governments and are based on the estate’s fair market value (FMV) rather than what the deceased initially paid for its assets. The tax is charged by the state where the dead individual resided at the time of death.

Key Takeaways

  • The estate tax is a monetary assessment imposed on an estate depending on the current market worth of its assets.
  • Federal estate taxes are payable on assets valued at more than $11.7 million in 2021 and $12.06 million in 2022.
  • Estate taxes exist in about one-fourth of the states, but with lesser exemptions.
  • Estate tax does not apply to assets transmitted to spouses.
  • Recipients of an estate’s assets may be liable to inheritance tax if they exceed specific thresholds.

How Federal Estate Taxes Work

The estate tax does not apply to assets given to a surviving spouse under what is known as the unlimited marital deduction. When the surviving spouse who inherited an estate dies, the beneficiaries may be required to pay estate taxes if the estate exceeds the exclusion level.

Estates with combined gross assets and past taxable gifts above $11.7 million (for 2021) and $12.06 million (for 2022) must file a federal estate tax return and pay estate tax as required.

In many cases, the effective estate tax rate in the United States is much lower than the highest federal statutory rate of 37%. This disparity exists in part because the tax is only levied on the portion of an estate that exceeds the exclusion limit.

Consider a $13 million estate to demonstrate the implications of the exclusions. With a $12.06 million exclusion limit in 2022, federal estate taxes would be required on $940,000 of the estate, or less than one-tenth of its entire assets. The rate in 2022 is 40%, thus the tax bill will be $376,000.

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Furthermore, estate holders and beneficiaries, or their lawyers, are always looking for new and inventive methods to safeguard major portions of an estate’s residual value from taxes by using discounts, deductions, and other legal tactics.

How State Estate Taxes Work

An estate that avoids federal taxes may nevertheless be taxed by the state in which the dead individual resided at the time of death. This is because state and local estate tax exclusions are just a fraction of the federal exclusion. However, estates worth less than $1,000,000 are not taxed in any jurisdiction.

Jurisdictions With Estate Taxes

The countries having estate taxes are shown below, with the threshold minimums at which they apply noted in parenthesis.

  • Connecticut($9,100,000)
  • ($4,254,800) District of Columbia
  • Hawaii ($5,490,000)
  • Illinois($4,000,000)
  • Maine($6,010,000)
  • Maryland($5,000,000)
  • Massachusetts($1,000,000)
  • Minnesota($3,000,000)
  • New York($6,110,000)
  • Oregon($1,000,000)
  • RhodeIsland ($1,648,611)
  • Vermont($5,000,000)
  • WashingtonState ($2,193,000)

Above specified criteria, the tax is normally applied on a sliding scale, similar to income tax brackets. In 2021, the tax rate is normally 18% or so for sums slightly over the threshold, and then gradually climbs to 39%. Some jurisdictions, such as Massachusetts, have estate tax rates as low as 0%, depending on the taxable value of the estate.

The Relationship Between Estate Tax and Gift Tax

Estate taxes are charged on an individual’s assets and estate after death, however they may be avoided if assets are gifted before death. The federal gift tax, on the other hand, applies to assets handed away in excess of specific restrictions while the taxpayer is still alive. The IRS states that the gift tax applies whether the giver intended the transfer to be a gift or not.

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Gift Tax Exclusion

The IRS, on the other hand, provides large gift exclusions. The yearly exclusion for 2021 is $15,000, which means that tax filers may donate up to $15,000 to each individual without paying tax on any of those gifts. The yearly exclusion for the 2022 tax year is $16,000.

They may also make tax-free presents up to the amount of the gift exclusion year after year. These restrictions make gifting an efficient means to minimize tax on assets donated to persons who may be liable to inheritance tax if the assets were transferred as part of an estate, such as non-family relatives.

Gift Exclusion Limit

If you make gifts that exceed the gift-exclusion limit, they are not taxed immediately and may never be taxed unless your estate is large. For you die, the amount exceeding the gift limit is documented and added to the taxable worth of your estate when computing estate tax.

Assume you elect to make a $76,000 contribution in 2022. Because the yearly exclusion is $16,000, you will be tax-free up to that amount. The remaining $60,000, on the other hand, must be reported on a 709 gift tax return. Your lifetime exclusion will be reduced by $60,000, as will your estate tax exclusion.

Because it is imposed on the assets of a dead person, the estate tax is often derisively referred to as a “death tax.”

Estate Tax vs. Inheritance Tax

An estate tax is levied on an estate before assets are distributed to beneficiaries. An inheritance tax, on the other hand, applies to assets after they have been inherited and is paid by the inheritor.

How an Inheritance Tax Works

There is no federal inheritance tax, and only a few states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania) have their own. Maryland is the only state that has both an estate and an inheritance tax.

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The state in which the inheritor resides assesses the inheritance tax. Your inheritance will be taxed, and at what rate, depending on its worth, your connection to the deceased, and the regulations and rates in effect where you reside.

An inheritance tax, like estate tax, is levied solely to the amount that exceeds the exemption. Above specified levels, the tax is normally levied on a sliding scale. Rates often start in the single digits and escalate to 15% to 19%. Your exemption and rate may differ depending on your connection to the dead.

Inheritance Tax Exceptions

Life insurance paid to a specified recipient is not normally subject to inheritance tax, however life insurance paid to the dead person or their estate is usually liable to estate tax.

In general, the lesser the rate, the closer your link to the deceased. In all six states, surviving spouses are immune from inheritance tax. Domestic partners are excluded as well in New Jersey. Except in Nebraska and Pennsylvania, descendants pay no inheritance tax.

Jurisdictions With Inheritance Tax

The countries that have inheritance taxes are listed here, with the minimal thresholds stated in parentheses.

  • Iowa($25,000)
  • Kentucky($500–$1,000)
  • Maryland($50,000–$100,000)
  • Nebraska($10,000–$40,000)
  • New Jersey(None to $25,000)
  • Pennsylvania(None to $3,500)

Because estate tax rates may be relatively high, persons with estates worth millions of dollars that they intend to leave to heirs or other beneficiaries should prepare carefully.

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