Last editedSep 20212 min read
They say that there are only two certainties in life: death and taxes. So, what happens when you combine the two, and what is the death tax? The term “death tax” refers to estate and inheritance taxes. Here’s what you need to know about state and federal death taxes, including how to plan for them.
Death tax explained
Death taxes are federal and state taxes imposed on the deceased’s estate after they pass away. They’re also called estate tax, inheritance tax, and death duties. With an estate tax, the departed’s estate is responsible to pay before assets can be transferred to a beneficiary. This is reversed with the inheritance tax, where the beneficiary pays before receiving their inheritance.
This one-time tax is only levied on estates over a certain threshold. Currently, this threshold is quite high – over $11 million. After you die, your beneficiaries must file the federal estate tax return within nine months. Death tax rates are imposed on a sliding scale depending on the estate’s value, typically between 18% and 40%.
Understanding estate tax
Most of the time, when the term “death tax” is used it’s referring to the federal estate tax. The specific amount owed will depend on the value of the full estate, which is calculated by tallying up the value of the owner’s property and assets. To work out the amount owed, the tax is based on the estate’s fair market value at the time of death.
Understanding inheritance tax
You’re unlikely to be liable for inheritance tax unless you live in a few select states, including:
The federal government only levies estate taxes, rather than inheritance tax. There are also exemptions for surviving spouses. With an inheritance tax, the beneficiary of the estate is responsible for filing a state tax return and paying any taxes owed once they’ve received their inheritance.
State vs federal death tax
The IRS taxes inheritance at the federal level, but you must also be aware of individual state requirements which can differ. Estate taxes are determined by where an individual legally resides when they die, while inheritance taxes are levied by the state where an inheritor currently lives.
Most states don’t levy estate taxes, but those that do have far lower thresholds than the federal exemption. For example, some states will charge an estate tax on inheritance over $1 million. It’s important to consider your state of residence when planning for estate tax.
How to minimize your death tax rate
The death tax rate is set so high that it only applies to a few individuals. For example, in 2018 the threshold for paying federal estate taxes was set at $10 million, adjusted to $11.18 million after taking inflation into account. This means that individuals can pass on over 11 million dollars to their loved ones without paying a penny in tax. Only the amount above this threshold would be subject to the federal death tax. If an individual has an estate worth $12.18 million, this means that only the $100,000 over the $11.18 threshold will be taxed.
There are additional options when it comes to minimizing estate and inheritance taxes. One example is the unified tax credit, which offers a fixed amount that you can gift to your inheritors during your lifetime before estate and gift taxes apply. It unifies the estate and gift taxes into a single system for better mileage.
Another way to minimize your tax load is to use the unlimited marital deduction, which allows one spouse to transfer unrestricted assets to the other without tax penalty. It essentially postpones the estate tax until the second spouse passes on and leaves the money to their own recipients.
Finally, you might wish to set up your assets in a trust structure. An intentionally defective grantor trust offers a way to separate estate tax from income tax. The grantor must pay income tax on revenue generated from the assets, but this is a way to bypass the gift tax.
Death and taxes can be complicated, so it’s worth consulting with an accountant or tax planner to make sure you’re taking advantage of all possible exemptions.
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