Estate Planning is complex - especially when you factor in the concept of taxes. If you want to truly understand all the benefits (and risks) involved with your Estate Plan, you need to have a comprehensive grasp on more than just the basics (like what a Will or Trust is).
It’s important to also understand the relationship between your Estate Plan and how any estate tax may or may not be associated with it.
What is an Estate Tax?
Estate tax is any tax your estate and/or your beneficiaries will assume so your estate can be managed and assets can be transferred appropriately, per your wishes, after you pass away.
There are two different types of tax we want to discuss in relation to Estate Planning. The first is federal estate tax, and the second is individual state tax.
An Explanation of Federal Estate Tax
Federal estate tax is any tax on your estate’s property and assets that’s due to the United States government after you pass away.
Wondering what can be taxed after your death? Cash, stocks, real estate and other property or other assets all might be subject to federal tax, if you have a large estate that is.
There’s good news though: most estates will not ever be required to pay federal tax to the IRS. As of 2020, only estates valued at $11.58 million per person, or $23.16 million per married couple, would be subject to federal estate tax. In October of 2020, the IRS announced a plan to increase this threshold to $11.7 million for individuals and $23.4 million for couples in 2021. Just as it is now, smaller estates are still expected to be exempt from federal tax. It remains to be seen what a new administration may do to limits and thresholds in the coming year.
An Explanation of State Estate Tax
Just because you have a smaller estate doesn’t necessarily mean you’re totally out of the woods, though. State taxes may still be due, and the amount would depend on the size of the estate, as well as the actual physical state the decedent lived in at the time of passing.
Like federal tax, the total value of an estate is the determining factor on how much, if any, state taxes would be due. Each state that requires state estate taxes (note that not every state does) has its own minimum threshold.
That said, estates valued at less than $1 million are not subject to state taxes, regardless of the state you’re in. And keep in mind, the actual tax due is based only on any value that’s over the minimum threshold. The rate is generally determined on a sliding basis. As noted, each state has its own tax rate, which currently can range from 7.8 percent (the lowest, in Connecticut) to 20 percent (the highest, in Washington).
State thresholds widely vary, as you can see in these examples from a few of the states that require state tax on estates:
Connecticut – $5.1 M
Hawaii – $5.5 M
Illinois – $4 M
Maine – $5.7 M
Maryland – $5 M
Massachusetts – $1 M
Minnesota – $3 M
New York – $5.9 M
Oregon – $1 M
Rhode Island – $1.6 M
Vermont – $2.8 M
Washington – $2.2 M
Washington DC – $5.8 M
***Note this data is current as of November, 2020. States and amounts can vary at any time; you should check your specific state when planning.***
Commonly Asked Questions about Estate Taxes
Like most things involved with taxes, estate tax can be confusing unless you have the right information. Read on for some of the most common questions around estate tax, as well as how each relates directly to Estate Planning.
Who Pays Estate Tax?
Who actually pays an estate tax depends on a few different things. First, the size of the estate and the state you’re in determines if and how much tax will be levied.
Another consideration when you’re dealing with federal estate tax is the size of the estate. Remember, as we’ve already discussed, the majority of estates will not meet the threshold to trigger federal tax - it’s only imposed on very large estates.
And finally, if you’re looking at estate taxes at the state level, note that not all states have an estate tax - the location of the estate comes into play too.
A couple other important notes about who is affected by the estate tax rule:
Federal tax would only be due on any amount that exceeds the threshold. For example, if an estate owned by a single woman who passed away in 2020 is worth $15 M, the tax due would be based on the $3.42 M that’s above the current $11.58 M minimum threshold.
Federal tax is calculated based on current values (not what the owner paid for any assets).
State tax would be due based on where the owner lived at the time of his or her death.
Estate taxes won’t be due on assets that transfer to a surviving spouse.
Beneficiaries of an estate may also be responsible for what’s known as an inheritance tax - we’ll go into more detail about that below.
Do I Have to Pay Taxes on an Estate?
Only very large, high-value estates will need to pay taxes. And if you’re a beneficiary or a Trustee of an estate, rest assured, any federal tax due would be paid for out of the actual estate - not from your pocket.
It’s worth pointing out again that estate taxes at the state level are determined by the state the decedent lived in at the time of his or her passing. By contrast, if you’re a beneficiary who’s subject to an inheritance tax, the state you live in would be a factor.
Estate Tax vs. Inheritance Tax - What’s the Difference?
Inheritance tax differs from federal estate tax in that when it comes to inheritance tax, it’s the beneficiary who’s responsible for any amount due (not the estate). The amount is calculated by the state the beneficiary lives in. In summary, it’s easiest to think of it like this:
Paid to the IRS or the state the decedent lived in
Not all states impose an estate tax
Based on the fair market value that exceeds the threshold (not the entire value)
Paid for out of the estate
Named beneficiaries have no impact on how much tax is due
Paid to the state the beneficiary lives in
Not all states have an inheritance tax - in fact, as of 2020, only the following 6 states do:
Based on the amount the beneficiary receives
Paid for by the beneficiary
Amount due depends on individual beneficiaries
Want to learn more? Check out our The Truth About Inheritance Tax Guide.
How to Avoid Estate Tax?
There are several strategic ways you can reduce or even completely eliminate estate taxes. With careful planning and some pretty simple tactics, you can confidently set up your estate to take advantage of the most effective solutions out there to minimize the amount of tax your estate and/or your loved ones will be responsible for after you pass away.
If married, use both estate tax exemptions - Unlimited portions of your estate can transfer to a surviving spouse with zero tax consequences (but be aware of potential pitfalls when the surviving spouse passes away).
Spend assets - Estate taxes are based on the value of your estate, so if you reduce that overall value, less taxes will be due when the time comes.
Gift assets - If you’re financially set in a way that allows, giving away part of your estate while you’re still alive could mean reducing the value of your estate enough to make a significant difference. Be wary of rules about gifting though. As of 2020, you can gift a max of $15,000 per recipient, per year, without having to report it. Larger gifts may have a tax consequence for the receiver.
Irrevocable Life Insurance Trust (ILIT) - Making an ILIT the owner of your life insurance policies is another way to potentially avoid taxes. It essentially eliminates the value of your insurance policies from your estate. Note you must survive a set number of years after creating an ILIT to receive all the tax benefits it offers.
Marriage - Married couples are exempt from federal estate tax, making the simple act of marriage a constructive way to avoid taxes on large estates.
How to Consider Estate Tax in Estate Planning
Estate Planning is one of the more complex, convoluted parts of “adulting” that we do. But honestly, it doesn’t have to be overwhelming. In fact, when you think about how incredibly important it is, how much impact it can have on your loved ones and your legacy, and how the benefits really are worth all the time and energy it takes to set up a concrete plan, it suddenly becomes a no brainer.
From taking inventory of your assets, to making long-term financial goals that’ll last your lifetime (and longer, protecting those you love), your Estate Plan can be the safeguard you’ve been looking for.
If you’re ready to draft a comprehensive plan, then you’re on the right path. Protecting your estate is more than just writing a Will or creating and funding a Trust. It’s thinking about estate tax implications that will be imposed after you pass away. And when you understand how to mitigate some (or maybe even all) of them, you can feel good about what you’ll one day leave behind.
Using the tools and strategies we’ve given you here, you can make sure you’ve done everything possible to set your estate up for success. Because now, you understand the difference between federal estate tax, taxes at the state level and even inheritance tax.
You work hard your whole life to care for your loved ones. You want to make your estate as iron-clad and lucrative as possible. Setting up your Estate Plan to be effective when it comes to estate tax is one more way to do just that.