Estate tax basics

In short

A friend of mine once told me he had built a good business and never gave a thought to what would happen to it afterward. You have probably felt that same pull to look away. Federal estate tax only touches estates above a limit, and that limit is the current figure, which the official source publishes each year. If your net worth sits well below it, the federal tax likely will not apply to you. If it sits near or above it, the time to learn the rules is now, while you can still choose. Some states run their own estate or inheritance tax with much lower limits, so check yours. Write down what you own, what you owe, and who gets what. Then talk with an estate attorney before you sign anything.

The whole of it

What it is

I once watched a neighbor spend a whole weekend sorting through his late father's papers. He was sad, and he was tired, and he kept saying he wished someone had left a map. That map is what good estate planning gives the people you love.

Your estate is everything you own when you die. That includes your home, your bank and brokerage accounts, your retirement accounts, your business interests, and the death benefit from life insurance you own. Debts and some costs come out of it. What remains is your net estate.

The federal estate tax is a tax on the right to pass that wealth to others. The estate pays it, not the heirs. It is a separate tax from the income tax. It only applies when the net estate is over a limit set by law, called the estate tax exemption.

Keep this in mind. Most of what people call the death tax touches only a small slice of families. Still, executives and high earners often have stock, options, and retirement money that add up faster than they expect.

How it works

You have probably added up your paycheck many times, but maybe never your whole estate. Start there. Add the fair market value of every asset you own or control, then subtract debts. The result is compared to the exemption.

If the net estate is below the exemption, the federal estate tax owed is zero. If it is above, the amount over the line is taxed at a rate set by law. That rate schedule tops out at the current figure, which the official source publishes each year on the part of an estate above the highest bracket.

A few rules matter a great deal. Assets left to a spouse who is a U.S. citizen generally pass free of estate tax. This is called the unlimited marital deduction. Gifts to a qualified charity also reduce the taxable estate.

Married couples have another tool. If the first spouse to die does not use the whole exemption, the leftover can move to the surviving spouse. This is called portability. You claim it by filing an estate tax return on time after the first death, even if no tax is due. Many families miss this step because no tax was owed, so it seemed pointless.

The tax also works alongside gifts. While you are alive, you can give up to the current figure, which the official source publishes each year to each person each year without using any of your lifetime exemption or filing a gift tax return. Bigger gifts are allowed, but they count against the lifetime exemption. The estate tax and the gift tax share one lifetime limit. That is worth knowing.

There is one more piece that surprises people. Federal tax law has long let assets you leave at death take a stepped up basis. That means the tax cost used to figure a future gain resets to the value on the date of death. An heir who later sells may owe little or no capital gains tax on growth that happened before then. Retirement accounts are the big exception, since withdrawals are still taxed as income.

Lawmakers have offered proposals to change this rule, so it may not stay as it is. Check the Internal Revenue Service before you count on it. The site fills in the date it last verified the rule, so look for that date.

The numbers, and where to find yours

I know how it feels to wonder if a number is still right. Tax limits move, and old articles go stale fast. So let me point you to the source rather than ask you to trust me.

The federal exemption is the current figure, which the official source publishes each year. The top rate is the current figure, which the official source publishes each year. The annual gift exclusion is the current figure, which the official source publishes each year. Each one is set by law and can change, and the site fills in the checked figure with its source and date.

For your own picture, gather a few things. Get statements for every account, the deed or a recent appraisal for real estate, and the value of any business you own. Find the face value of life insurance policies you own, and list your debts. Note the beneficiary named on each retirement account and insurance policy, because those forms often override a will.

The official place to confirm the rules is the Internal Revenue Service. It publishes Form 706, the United States Estate (and Generation Skipping Transfer) Tax Return, along with its instructions, and Form 709 for gift tax. Your state revenue department will explain any state estate or inheritance tax.

A worked example

A friend of mine, whom I will call Marcus, is a vice president at a manufacturing firm. He is 58 and married to Elena, who is 56. They live in a state with no estate tax, so only the federal rules matter for them. The figures below are Marcus's own plain numbers, chosen for the example only.

Their home is worth 900,000 dollars, with a mortgage of 200,000 dollars. Marcus has 1,400,000 dollars in his 401(k) and Elena has 600,000 dollars in her IRA. They hold 700,000 dollars in taxable investment accounts and 100,000 dollars in cash. Marcus owns a life insurance policy with a death benefit of 1,000,000 dollars.

Add the assets. 900,000 plus 1,400,000 plus 600,000 plus 700,000 plus 100,000 plus 1,000,000 equals 4,700,000 dollars. Subtract the mortgage of 200,000 dollars. The net estate is 4,500,000 dollars.

Marcus compares this to the exemption, which is the current figure, which the official source publishes each year. He looks up the current figure from the source the site gives him. If his net estate is below it, no federal estate tax would be owed on his death. If Marcus dies first and leaves everything to Elena, the marital deduction means no estate tax at that point either.

Now he checks the second death. When Elena later dies, whatever she still holds is tested against her own exemption plus any portability she inherited. Marcus learns that his family must file Form 706 after his death to preserve that portability. That was the piece he did not know.

He also notes that the life insurance, owned by him, counts in his estate. He talks with an attorney about whether holding it inside a trust makes sense. He does not decide on the spot. He simply leaves the meeting knowing which questions to ask, and that feels like a real gain.

Where it goes wrong

I once watched a family argue for a year over a house because no one had named who should get it. The tax was not even the problem. The silence was.

The first common mistake is guessing at net worth. People forget that insurance, retirement accounts, and business shares all count. Add them honestly.

The second is ignoring beneficiary forms. A retirement account goes to whoever is named on the form, whatever your will says. An old form can send money to a former spouse. Check yours.

The third is skipping the portability filing. If you are married and the first spouse dies, filing on time can save the survivor a great deal later. It costs effort now and protects the family later.

The fourth is forgetting the state. A state may tax estates or inheritances at far lower levels than the federal limit. Your state revenue department is the place to confirm.

The fifth is waiting. Laws change, and the exemption has been raised and lowered before. Do not build a plan on one year's figures and never look again. Review it when your life changes, when the law changes, or every few years.

The last is doing it alone in the dark. A good estate attorney and a tax professional are worth what they cost. Ask what they charge, ask how they are paid, and ask them to explain anything you do not follow.

Questions to answer before you leave this page

What is my net estate today, once I add every asset and subtract every debt? Have I compared that figure to the current federal exemption from the official source? Does my state have its own estate or inheritance tax, and at what level? Who is named on each retirement account and insurance policy, and is that still what I want? If I am married, does my spouse know where the papers are, and do we understand portability? Do I own life insurance that counts in my estate, and have I asked an attorney about it? Have I written down who should get what, and who should be in charge? When will I sit down with a professional to check all of this?