Understanding Death Taxes
Death taxes refer to the taxes imposed by federal and select state governments on an individual’s estate after their demise. These taxes are imposed on the beneficiary who inherits assets as per the deceased’s will or on the estate that settles the tax prior to transferring the inherited property.
Also known as death duties, estate taxes, or inheritance taxes, death taxes are a crucial aspect of financial planning and asset distribution.
Key Takeaways
- Death taxes are levies by governments on an individual’s estate after their passing.
- They encompass estate and inheritance taxes, commonly known as death duties.
- Death taxes typically apply to estates exceeding a specific threshold value. For instance, in 2023, an estate must surpass $12.92 million to be subject to federal taxes, increasing to $13.61 million in 2024.
Understanding Death Taxes
Death taxes encompass any tax imposed on property transfers following an individual’s death. Coined in the 1990s, the term “death tax” was used to describe estate and inheritance taxes by individuals seeking their repeal. In the case of estate taxes, the deceased’s estate settles the tax before transferring assets to the beneficiary, whereas inheritance taxes are paid by the receiver of the assets.
The federal estate tax, enforced by the federal government and certain states, is based on the property and asset value at the owner’s time of demise. The federal estate tax rate ranges between 18% and 40% of the inheritance amount.
Notably, twelve states have a separate state estate tax in addition to federal obligations. These states are Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington, and the District of Columbia.
While the federal government does not impose inheritance tax, several states including Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania do have such taxes. However, exemptions are provided for surviving spouses in all these states. Nebraska and Pennsylvania may levy taxes on property transference to a child or grandchild under specific circumstances.
Death Tax Thresholds
The majority of individuals often do not pay death taxes since they are applicable only to a select few. This is due to the 2017 Tax Cuts and Jobs Act, which linked the estate tax to the basic exclusion amount, set at $12.92 million in 2023 and $13.61 million in 2024.
For instance, if an individual leaves an estate valued at $13 million (adjusted for inflation) excluding non-exempt assets to their children and has not exceeded the exclusion amount in gifts, the surplus above the federal level in 2023 will be subject to estate tax. As per the Unified Rate Schedule, the taxable amount incurs a 28% tax along with a base tax, resulting in a death tax liability.
Decedents with estates valued below the applicable exemption amount for the year of death are exempt from federal estate taxes.
Unified Tax Credit
The unified tax credit allows individuals to gift a set amount during their lifetime before incurring death or gift taxes. By combining gift and estate taxes into a single system, this credit reduces the tax liability dollar for dollar.
Individuals often utilize the unified tax credit to mitigate estate taxes after their demise, as it cannot be applied to gift taxes during their lifetime but can be used for reducing taxes on inherited amounts left to beneficiaries.
Unlimited Marital Deduction
Another strategy to reduce death taxes is the unlimited marital deduction, enabling individuals to transfer assets to their spouse without tax implications, even posthumously.
This provision eliminates federal estate and gift taxes on property transfers between spouses, treating them as a single economic entity. Transfers to surviving spouses are facilitated through an unlimited deduction from estate and gift taxes, deferring tax payments on inherited properties until the second spouse’s demise.
By delaying estate tax payments until the surviving spouse’s death, the unlimited marital deduction allows married couples to preserve assets and potentially reduce tax burdens.
Advantages and Disadvantages of Death Taxes
Advantages
- High threshold: Death taxes are applicable when estates exceed $12.92 million in 2023 and $13.61 million in 2024, affecting only the affluent.
- High tax revenue: Government data as of Oct. 31, 2023, shows $4 billion in estate and gift tax revenues collected during the fiscal year.
Disadvantages
- Double taxes: Individuals with large estates subject to death taxes may be taxed twice—first with income taxes and then with the estate tax.
- Loopholes: There are strategies to evade estate taxes, prompting wealthy individuals to use these loopholes to circumvent tax obligations.
Pros
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High threshold
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High tax revenue
Cons
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Double taxes
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Loopholes
How to Reduce or Avoid Death Taxes
Death taxes may not concern most individuals as they typically do not possess assets exceeding the $12.92 million threshold. Nonetheless, in the event that this changes post-2025 due to a potential revision in the Tax Cuts and Jobs Act, measures can be taken to minimize or prevent these taxes.
Individuals anticipating or possessing adequate assets to trigger death taxes can adopt several strategies to either reduce or eliminate these taxes.
- Create an irrevocable trust: Shield your assets from estate taxes by placing them in an irrevocable trust, which can subsequently distribute funds to both you and your beneficiaries as income, reducing the overall tax burden. A common trust utilized for this purpose is a grantor retained annuity trust (GRAT).
- Gift assets to family and friends: Gifts to relatives and friends can be tax-free as long as they do not surpass the lifetime exclusion limit.
- Utilize your wealth: Mitigate estate taxes by distributing enough assets to ensure financial stability for your family and then enjoy the fruits of your labor.
- Engage in charitable donations: Apart from contributing to causes you believe in, you can deduct contributions from your estate, potentially alleviating tax obligations.
How Do You Avoid Death Taxes?
Most individuals are unlikely to incur estate taxes, commonly referred to as the death tax. However, for individuals possessing $12.92 million or more in assets in 2023 or $13.61 million in 2024, strategies such as charitable donations, planned gifting, or trust fund arrangements can be employed to avert tax liabilities.
What States Have Death Taxes?
Twelve states and the District of Columbia enforce estate taxes: Connecticut, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, Washington, and the District of Columbia.
What Is the Difference Between an Estate Tax and an Inheritance Tax?
The estate tax is paid by the deceased’s estate while the inheritance tax is shouldered by the heirs of the deceased.
The Bottom Line
The death tax, synonymous with estate taxes, applies to an individual’s estate posthumously. With a threshold of over $12.92 million in 2023 or $13.61 million in 2024, most individuals may not need to fret about estate taxes. For those affected, various strategies can be implemented to minimize or prevent these tax implications.