What Is Estate Tax?

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  • What is estate tax? Find out how estate tax works, where it applies and who's likely to owe this tax. Learn about how estate tax differs from other taxes.

If you're making a will or other plans for your estate, you may be worried about whether your assets will truly be distributed according to your wishes. Writing up estate documents that are clear and comply with the law can help avoid problems, but you may still be wondering how taxes could impact your estate. What is estate tax, and will it apply to you? 

What Is Estate Tax? 

According to the IRS, estate tax is "a tax on your right to transfer property at your death." Estates with a value above a set amount must pay this tax. 

It's important to note that the estate, not the beneficiaries, must pay this tax. In other words, the people or organizations who inherit aren't responsible for paying this tax. Because the estate must pay the tax, it's worthwhile to consider any estate taxes in advance to know how much money will be available for heirs. 

Who Owes Estate Taxes?

While estate tax sounds like a significant financial burden, most people won't need to worry about it. Federal estate tax only applies to amounts over the federal exclusion limit. In 2022 this limit is $12,060,000. Only amounts over this limit are taxed, so estates valued at less than $12 million don't own any tax. An estate valued at $13 million would owe taxes on $940,000 because only the amount over the limit is taxed. 

If you have property or assets that have increased in value, you should know that the IRS looks at your estate's current fair market value, not what you originally paid for the property. An estate may consist of money, stocks, real estate, business interests and other property. 

Some states also have estate taxes, and the exclusion limits can be lower.
These states include:

  • Connecticut
  • Hawaii
  • Illinois
  • Maine
  • Maryland 
  • Massachusetts
  • Minnesota
  • New York
  • Oregon
  • Rhode Island
  • Vermont
  • Virginia 

The District of Columbia also imposes its own estate tax. If you live in one of these places, you could owe estate taxes to a state even if you don't owe them on federal taxes. Some states have limits as low as $1 million.

What Is the Difference Between Estate Tax and Inheritance Tax?

Unlike estate taxes, inheritance tax is owed by a person who inherits money or property. There's no federal inheritance tax, but a few states do require beneficiaries to pay taxes on inheritances. These states include:

  • Iowa 
  • Kentucky 
  • Maryland
  • Nebraska 
  • New Jersey 
  • Pennsylvania

Gift tax is yet another kind of tax. Gift tax is owed by a person who gives an amount over an exclusion limit. As of 2022, an individual can gift up to $16,000 per person annually without incurring federal gift tax. 

How Can You Avoid Estate Tax?

If you think state or federal estate taxes might impact you, speaking with a lawyer or financial planner can be helpful. Estates with enough value to be affected by these taxes can also have complex issues, and you may benefit from professional advice. 

Some general techniques for avoiding estate taxes include: 

  • Leave everything to your spouse. Estate taxes don't apply to transfers to your spouse. 
  • Provide gifts during your lifetime. Although you must be careful to avoid gift taxes or allegations of fraud, providing gifts, especially to family members, can help you avoid estate taxes. 
  • Include children in your business now. If you have a valuable company that you wish to leave to your children or another person, making them a partner in the business while you're still alive can be a wise choice. This reduces the value of your interest and can help you avoid taxes. 
  • Use a trust. Some kinds of trusts, such as irrevocable life insurance trusts, can convert some of your money to assets that won't be taxed upon your death. 

Understanding estate tax and how it works can help you make the best plan for your assets. If you're worried about estate taxes and looking for ways to minimize what you'll owe, consider speaking with a professional. These major financial decisions can significantly affect your life and your estate. 

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