Estate taxes, commonly referred to by their nickname — death taxes — are a highly controversial aspect of the federal tax code. Many people on both sides of the political aisle feel that paying a death tax is unfair. However, many people don’t realize that most estates are exempt from paying these taxes.
Below, we’ve outlined a few key points about death taxes, how they work and how you can minimize your tax bill and safeguard your legacy.
What are death taxes?
In general, death taxes are taxes imposed by the federal government or individual states on someone’s estate after they pass away. The federal estate tax and state inheritance tax are often lumped together as “death taxes,” — however, they are two distinct forms of taxation.
Most states don’t impose an estate tax or an inheritance tax. Only a handful of states continue to charge estate taxes. The death tax states are:
- New York
- Rhode Island
The states outlined above, as well as Washington D.C., all charge estate taxes. Each state has its own exemption limits. For example, Connecticut only taxes estates valued above $9.1 million. Five states charge inheritance taxes (taxes on beneficiaries) but do not tax the estate itself. Those states are Iowa, Kentucky, Nebraska, New Jersey, and Pennsylvania. Maryland is the only state that has both an estate and inheritance tax.
How do death taxes work?
The federal government imposes the federal estate tax, and the Internal Revenue Service (IRS) collects it. The tax is based on the fair market value of what you own at the time of your death. As of 2022, a person can pass away with up to $12.6 million in assets before the 40% federal estate tax applies. Due to these high exemption limits, death taxes are perceived as a tax on the wealthy.
Assets that are included in your estate and therefore subject to the estate tax (if you’re over the exemption limit) include:
- Real estate
- Retirement accounts
- Business interests
- Personal items
The estate tax applies regardless of who the estate passes to, but there are deductions for assets left to a surviving spouse and for assets left to a charitable organization.
Estate tax vs. inheritance tax
Both estate and inheritance taxes fall under the “death tax” umbrella. However, there are a few key differences.
For one, the estate tax is imposed on the federal and state level. On the other hand, there is no federally mandated inheritance tax on those who inherit assets (your heirs or beneficiaries). As noted above, only five states impose taxes on those who inherit.
Unlike the estate tax — which is assessed on the value of your estate when you pass away — the inheritance tax is levied on the value of the inheritance received by your beneficiaries. Therefore, your heirs are subject to the death tax, not the estate.
How do I know if I owe death taxes?
Whether or not you will owe death taxes depends on the value of the estate you are leaving behind as well as where you live. As mentioned above, there is an estate tax imposed on the federal level. As of 2022, your estate must be worth $12.6 million or more to be subject to the tax. If the value of your estate is below that number, you do not owe federal estate taxes.
However, you may owe estate taxes if you live in one of the eleven states listed above or Washington, D.C. Estate tax rates and exemption limits vary by state, so it’s crucial to review the specific rules where you live.
If you are a beneficiary of an inheritance, you will not pay taxes on the federal level. However, several states levy an inheritance tax, so be sure to confirm whether you live in a state that imposes the tax.
Is there a way to avoid death taxes?
One component of estate planning is ensuring that you arrange your estate to minimize the tax burden to your survivors. Periodically, you should monitor your entire estate's fair market value and compare it to the appropriate federal and state inheritance tax thresholds.
Though there may not be a way to avoid death taxes in some cases, there are certain things you can do during your lifetime to minimize the impact of these taxes upon your death. For example, in 2021, you can donate up to $15,000 to as many people as you wish without any gift or estate tax consequences.
Be aware that If you donate more than $15,000 to someone in a single calendar year, you must report the gifts on a federal gift tax return and notify the IRS that you are using a portion of your estate tax exemption. People who want to minimize the effect of the estate tax or inheritance tax may make gifts each year to their children and grandchildren to remove assets from their taxable estate.
If it appears that your estate or your beneficiaries will be subject to a death tax, you can take specific actions during your lifetime to reduce the impact of these taxes, such as annual giving to your heirs.
Though death taxes are a hot-button issue, the vast majority of estates will not have to pay them — thanks to high exemption limits (especially on the federal level). State exemption amounts tend to be lower than the federal limit, which is why it’s important to review the rules where you live.