How Estate Taxes Work

The only way to pass on your entire estate without paying tax is by giving 100% of it to your spouse. When heirs other than a spouse receive assets from an estate, tax liabilities arise. There are five main types of taxes that your estate or your heirs may need to pay upon your death:

It’s important to understand what these taxes are since you obviously will want to minimize the bite that taxes will take out of the estate you pass on to your heirs. To determine which taxes might apply to your estate and your heirs, consult a tax advisor. Unless otherwise stated, all tax information in this guide refers to federal, not state, regulations.

The federal government assesses estate taxes on estates that exceed the allowable exemption amount (currently $2 million) in the year in which a person dies. Estate tax rates on funds that exceed the exemption can reach almost 50%. Taxes are applied to all the assets in the estate but only to some assets held in trusts, which is why establishing a trust or trusts can be an important estate planning tool for some individuals. Estate taxes are paid by the estate’s executor (the personal representative of the estate), appointed previously by the decedent (deceased person) or by a court-appointed representative if the executor appointed by the decedent is unable to serve.

If you receive any income, dividends, capital gains, rents, royalties, or interest during the year you die, your executor must file federal and state income tax returns (in addition to an estate tax return) on your behalf.

Like the federal government, most states assess a tax on the estate of any individual who dies with taxable assets of a value exceeding a certain exemption amount. These are known as state estate taxes. Most states follow the federal government’s exemption amounts. Typically, the federal government grants a credit against federal estate taxes for paid state estate taxes to avoid double taxation.

State laws can have a significant impact on your estate planning strategy. For example, if you own property in two states, you’ll likely be subject to the tax laws of both states. (See Probate for more about the estate planning and tax ramifications of owning property in two or more states.)

Inheritance taxes are taxes assessed by states that your heirs—not your estate—must pay upon your death. The government does not normally give credit against federal estate taxes for payment of inheritance taxes since inheritance taxes are not paid by the estate.

If your assets appreciate while going through probate, your estate (and therefore your heirs) may owe additional capital gains taxes.

The allowable exemption amount for federal and state estate taxes can shift depending on acts of federal or state legislatures. In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act, which set the federal estate tax rate and exemption amount according to the following table.

Note that the estate tax is completely repealed in 2010—but only for that year—and that in the following year the exemption is currently slated to fall to $1 million. All of these rates are subject to change should Congress choose to modify them at any point between now and 2011. To be safe, you should act as if any estate over $1 million may get hit by the Federal Estate Tax.

To evaluate whether you’ll have $1 million in assets when you die, consider the current value of your real estate property, retirement plans, savings, investments, potential inheritances, and other personal property (jewelry, cars, and so forth). Then allow for the value of most assets (real estate and other investments) to double once every 10–12 years.