Understanding Estate Tax – What It Is and How It Works

An estate tax is a levy imposed on the value of an estate above a threshold amount. The tax may be avoided with proper planning.

Thanks to various deductions and discounts, the effective rate is far lower than the top statutory rate. Revenues from the tax last year were less than 0.1 percent of GDP.

What is an estate?

An estate is essentially everything a person owns at the time of death, including real estate, bank accounts, investment assets, life insurance policies, personal possessions, and even rights to intellectual property. An estate may also include debts, such as credit card or mortgage balances and tax obligations.

When someone dies, their family must file an estate tax return to outline their assets and values. It’s similar to an income tax return but with more details.

In addition to the value of a decedent’s assets, an estate tax return looks at lifetime gifts made. For example, if a person gives away a lot of money during their life and then dies with a vast estate, they may be subject to an inheritance tax (or estate tax).

The 2017 tax act doubled the federal estate, gift, and GST exemption amounts through 2025. Many states impose their estate taxes as well. Some apply special provisions to reduce the amount of tax or spread it out over time.

What is a taxable estate?

In the most basic terms, a person’s taxable estate is what is left behind after death. This includes all assets less liabilities that they own. It is important to note that federal and state estate taxes are only levied when a person’s assets exceed some minimum threshold amount. Surviving spouses are generally exempt from these levies.

During calculating a taxable estate, certain deductions are taken into account. These include mortgages and other debt, funeral expenses, estate administration costs, property passed on to charity, and some operating business or farm property. In addition, the value of lifetime taxable gifts is taken into account.

The resulting net estate is then compared to the filing threshold for that year, currently $11.7 million (it will change in 2023). Those who do not meet or exceed this amount must file an estate tax return. An experienced Illinois estate planning lawyer can help you ensure all necessary steps are taken to minimize your taxable estate. This is one way to protect your loved ones from estate taxes.

What is a tax-free estate?

The estate tax in California is part of the federal unified gift and estate tax system. The system is designed to tax wealth transfers from a deceased person’s estate and inheritance to their beneficiaries.

The taxes are based on the fair market value of an individual’s assets at death (Refer to Form 706PDF), not their original cost or peak values. This valuation approach allows for asset appreciation over time and protects against being taxed on declining asset prices after death.

For the few estates that do pay estate taxes, average effective tax rates are far below the top statutory rate of 40 percent. Moreover, empirical evidence shows that the estate tax does not discourage saving or investment, contrary to some claims by advocates of its repeal.

Talking with your tax and legal advisors is essential to make significant gifts to loved ones. They can help you plan your skills and structure your trusts to minimize potential estate tax exposure. Alternatively, consider revocable life insurance trusts that allow you to donate money directly to your family members for education or medical expenses.

Who pays the estate tax?

The estate tax affects a small group of people, including heirs and those who use estate planning strategies to avoid or lessen the tax. However, few people pay the tax, and the amount they pay is usually small relative to their wealth. According to Urban-Brookings, in 2018, only about 5,500 people had estates large enough to require filing an estate tax return. After deductions, credits, and other adjustments, only 1,900 owed the tax. Most who owe the tax belong to the top 10 percent of income earners, and more than a third are in the top 0.1 percent.

Most American families don’t pay any estate tax, as the exemption levels are high. However, the Trump administration’s proposal to repeal the federal estate tax is still in play. If that happens, it could significantly impact the estates of the top 0.2 percent earners. Fortunately, there are other ways to reduce the value of one’s estate, including gifting assets during life. However, these strategies have complications and may incur gift and income taxes.

How does the tax work?

Many deductions (and, in some particular circumstances, reductions to value) are allowed in arriving at the net amount of a decedent’s taxable estate. These include mortgages and other debts, estate administration expenses, property that passes to surviving spouses, and qualified charities. The value of lifetime taxable gifts is also added to this total, and a unified credit is available to reduce the tax.

In 2020, estate and gift taxes raised $17.6 billion, about 0.1 percent of GDP. This compares to annual revenues of close to zero and a share of 0.2 percent of GDP before 1980 the taxes first appeared.

In general, only about 7 percent of all estates pay the top statutory rate of 40 percent. That’s far below claims by repeal proponents that the tax consumes nearly half of all wealth. The tax also creates incentives for some people to save more. For example, it prevents heirs from paying capital gains taxes on appreciated assets they inherit because their cost basis is “stepped up” to fair market value at death.

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