How Estate Taxes Work, A Real Life Example

In the United States, the estate tax, also commonly referred to as an inheritance tax, or pejoratively, a "death tax," is a financial levy on a beneficiary’s portion of an estate, usually on assets and other financial inheritances received by the estate’s heirs. This tax is not applied to assets transferred to a surviving spouse. Heirs or beneficiaries only pay this tax when the amount of the estate that they inherit is greater than the exclusion limit established by the Internal Revenue Service (IRS). As of 2016, the exclusion limit is $5.45 million; thus, the estate tax is only levied on a very limited number of estates.

Most individuals spend the entirety of their lives compiling finances and assets that are inevitably left to a surviving spouse or passed on to a designated heir or beneficiary. Ultimately, a carefully planned estate is essential for individuals who plan to leave behind sizable assets to heirs, while avoiding the necessity of paying an extremely high estate tax bill.

The application of estate tax varies and is dependent on a number of factors, primarily federal laws within the United States, but also partially on estate or inheritance tax laws in each respective state, and potentially on international law. Each state is responsible for establishing the percentage at which an estate is taxed at the state level, and states may offer additional exclusions to payment of estate taxes beyond the IRS exclusion limit.

The freedom to transfer, or bequeath, assets from an estate to a living spouse is known as the unlimited marital deduction and can be done without any estate tax being levied. If the designated living spouse passes away, however, the beneficiaries of the remaining estate will likely be required to pay the estate tax on the total estate value that surpasses the exclusion limit.

Consider, for example, that a married entrepreneur has amassed an estate worth $12 million. When the individual passes away, he can freely and clearly bequeath the entirety of the estate to his wife and she will not be charged any estate taxes.

Now further assume that the entrepreneur and his wife have established their two children as beneficiaries, or heirs, of the estate in the event that both he and his wife die. The wife ends up living for several years without her husband, spending the equivalent of $2 million worth of the estate before passing away. Upon her death, their children receive the remaining estate, worth approximately $10 million. In this instance, the total of the remaining estate exceeds the exclusion limit. The heirs are required to pay estate taxes at up to a 50% rate, including both federal and state estate taxes, on the amount of the estate beyond the exclusion limit. This means that each heir gets roughly $2.7 million from the $10 million.

In many instances, the effective U.S. estate tax rate is substantially lower than the top federal statutory rate of 40%. This happens for two primary reasons. First, estate taxes are owed only on the portion of an estate that exceeds the exclusion limit. To put this into perspective, consider an estate worth $7 million. With the 2016 exclusion limit of $5.45 million, estate taxes are owed on less than $2 million, or somewhere between one-fourth and one-fifth of the total estate. Second, estate holders and beneficiaries, or their attorneys, continually find new and creative ways to protect significant chunks of an estate’s remaining value from taxes by taking advantage of discounts, deductions and loopholes that have been enacted by policymakers over the years.