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Taxes are rarely anyone’s favourite subject, and paired with the emotional weight of estate planning they become genuinely contentious. Advocates coined the phrase “death tax” for the transfer of wealth from a deceased person to their heirs. The formal name is the federal estate tax, and for business owners and families approaching retirement, understanding how it actually operates matters more than the politics around it.
What the Federal Estate Tax Actually Is
Unlike income tax, which climbs through brackets, the federal estate tax is a flat rate applied only to the value of an estate above a statutory exemption. The rate has long sat at 40 percent on the excess.
The federal government says they have a federal tax on your estate depending on the value of it. It is 40%. Now there’s a threshold of who that applies to.
Renee Parris, Estate Planning, Simplified
To know whether it touches you, you first calculate your gross estate. That is not just cash in the bank. It is the fair market value of everything you own or hold an interest in on the date of death: your home, any second property, commercial real estate, business interests, brokerage accounts, personal property such as art and jewellery, and — a detail that surprises people — the face value of any life insurance policy you own on your own life.
Add it all together. Below the exemption, the estate owes nothing federally. Above it, the 40 percent applies to the excess only.
The Exemption Is a Moving Target
This is the part worth understanding properly, because the number itself changes.
The exemption is adjusted annually for inflation and has been altered substantially by legislation more than once in the past decade — roughly doubled under the 2017 tax law, with a scheduled expiry that has since been the subject of further legislation and negotiation. The practical consequence is that the figure in force when you read this may differ from the figure in force when a plan was drafted, and from the figure that applies on the date of your death.
Dates matter and thresholds matter. It goes up every year. If Congress doesn’t extend it for another period of time, they may, they may not. We don’t know what they’re going to do because we don’t know who’s going to be in office or in Congress.
Renee Parris, Estate Planning, Simplified
For that reason this article deliberately does not quote a current dollar figure. Any family whose total estate is anywhere near the range where this tax could apply should verify the exemption in force with a tax professional, and re-verify it periodically rather than relying on a number from an old plan.
How the Calculation Works
The tax is not levied on the estate from the first dollar. It applies only to the amount above the exemption.
If your estate put everything that you own together, calculate it as one number, it’s 20 million. The threshold says everything above the exemption. So that gap, your family will pay 40% taxation on. So anything above the threshold, whatever the threshold is when you’re watching this, is what that 40% calculation will be on, the excess above that amount, which can be substantial and sizable.
Renee Parris, Estate Planning, Simplified
The reason this matters so much is liquidity, not arithmetic. Federal estate tax is generally due roughly nine months after death. If an estate is largely a family business or commercial property but holds little cash, heirs can be forced into a rushed sale of the very asset the plan was meant to preserve, purely to pay the bill on time.
State Taxes Are a Separate Question
Alongside the federal tax, states run their own systems, and they come in two distinct forms.
- A state estate tax is levied on the estate itself before distribution, with its own exemption that is often considerably lower than the federal one.
- An inheritance tax is levied on the individual heirs who receive assets, with the rate usually depending on the heir’s relationship to the deceased. Spouses and children typically pay little or nothing; more distant relatives, friends and unmarried partners can pay significantly more.
There are some states who have two different types of estate taxes. Not every state has both or either. Some states have none. Those thresholds change depending on who’s in the legislative body. So every two to four years when you send new people to your state senate and congress, they have the ability to change estate laws and tax laws. So that’s why we say that that’s a moving target.
Renee Parris, Estate Planning, Simplified
Only a minority of states levy an inheritance tax, and a different set impose a state estate tax. Knowing which category your state falls into, and whether that has changed recently, is a basic part of planning.
Solving the Liquidity Problem
Where a liability is likely, the established tool is an irrevocable life insurance trust. The trust owns a policy on your life and is its beneficiary. Because the trust is irrevocable, the policy proceeds are generally excluded from your taxable estate. On your death the trust receives cash, which the trustee can use to buy assets from the estate or lend it money — providing exactly the liquidity needed to settle the tax without selling the house or the business.
One of the solutions to that is setting up an irrevocable life insurance trust that will pay those taxes. So just know there are ways we can help with that.
Renee Parris, Estate Planning, Simplified
Who Actually Needs to Worry
For most families the federal estate tax is not a live concern, because their total assets sit well below the exemption. The people who should be paying attention are those whose estates are near the threshold, those whose estates are likely to grow into it, and anyone in a state with its own estate or inheritance tax at a lower limit.
The exemption is on a clock and subject to politics. That is precisely why the planning is worth doing before you need it, and why the numbers deserve a fresh look every few years rather than once.
Sources
- Renee Parris, Estate Planning, Simplified, Module 6, Lesson 1 — course transcript.
- Internal Revenue Code provisions governing the federal estate tax, the unified credit and the exclusion amount, which is indexed annually and has been modified by legislation.
This article is for educational purposes only and does not constitute legal, tax, or financial advice. Federal and state exemption amounts, rates and filing deadlines change and are subject to legislation. Verify the figures that currently apply with a licensed tax professional or estate planning attorney before acting.
About the instructor: Renee Parris is an estate planning educator with over 30 years of experience. This article is a companion piece to Renee’s course, Estate Planning, Simplified.
