Estate tax: who it actually affects

Estate tax generates anxiety far in excess of the number of estates that pay it. The state-level picture is a different matter.

The federal position

A federal estate tax applies to estates above an exemption amount, which is indexed and has been at a historically high level in recent years.

The practical result is that a very small percentage of estates — well under one per cent — pay federal estate tax.

The exemption is scheduled to change under existing legislation, which creates genuine planning uncertainty for larger estates and is a reason for those affected to keep arrangements under review.

A unified system applies: lifetime gifts above the annual exclusion reduce the exemption available at death, so the two are not separate allowances.

Portability

An important feature for married couples.

A surviving spouse can generally use the unused portion of a deceased spouse's exemption, effectively doubling the amount available.

The critical condition: portability is not automatic. An estate tax return must be filed for the first spouse's estate to elect it, even where no tax is due and no return would otherwise be required.

Failing to file that return forfeits the unused exemption, and this happens routinely because the estate was well below the threshold and nobody saw a reason to file.

For any married couple whose combined assets might approach the exemption — particularly given scheduled changes — filing to preserve portability is inexpensive insurance.

The unlimited marital deduction

Assets passing to a surviving spouse who is a citizen generally pass free of estate tax without limit.

Which defers rather than eliminates the tax, since the assets are then in the survivor's estate.

Different rules apply where the surviving spouse is not a citizen, and specific trust arrangements exist to address that situation.

State estate and inheritance taxes

Where the broader exposure lies.

A minority of states impose their own estate tax, and several have exemption thresholds substantially below the federal one.

A few states impose an inheritance tax, which is levied on the recipient rather than the estate, with rates typically depending on the relationship to the deceased. Close relatives are frequently exempt or taxed lightly; more distant beneficiaries and unrelated individuals face higher rates.

One state has both.

Not all states offer portability at state level, which means the planning that works federally may not work for state purposes.

The practical implication: an estate well below the federal threshold may still face a state liability, and this affects a much broader group than federal estate tax does.

Checking your own state's rules is worthwhile for anyone with a substantial estate, and particularly for anyone considering relocation.

What is included in the estate

Broader than people expect.

All property owned at death, including the home and its contents.

Retirement accounts.

Life insurance proceeds, where the deceased held incidents of ownership in the policy.

This last item catches people. A policy paying a substantial death benefit is included in the taxable estate if the deceased owned it, which can push an otherwise modest estate over a state threshold.

Business interests, at fair market value.

Certain gifts made within defined periods before death.

Basic reduction techniques

For estates that are actually exposed.

Lifetime gifting within the annual exclusion, which removes assets and their future growth from the estate without using the lifetime exemption.

Direct payment of tuition and medical expenses, which is excluded entirely.

Charitable bequests, which are deductible.

Irrevocable life insurance trusts, which can remove policy proceeds from the taxable estate.

Various trust structures designed to transfer future appreciation out of the estate.

These involve complexity, cost and irrevocability, and they are worth the effort only where there is genuine exposure.

The basis consideration

A point that runs the other way and is frequently missed.

Assets held at death generally receive a basis adjustment to market value, eliminating capital gains tax on the appreciation.

Gifted assets carry over the original basis.

Which means that for estates below the estate tax threshold, holding appreciated assets until death is generally better for the family than gifting them during life.

Aggressive gifting to reduce an estate that would never have been taxed can produce a worse outcome by forfeiting the basis adjustment.

General information only, not legal or tax advice. Exemption amounts and state rules change — consult a qualified estate attorney or tax professional.