Everything you need to understand Estate Taxes: A Basic Overview!

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The accumulated money and property by an individual over their lifetime can be referred to as their estate. A person’s estate is their net worth. A person’s net worth can be calculated at any point in time – while the person is alive or dead. The person’s estate net worth is calculated as the sum of the all the person’s assets – legal rights, interests or property less the all the person’s liabilities at the time of calculation. What happens when a person dies and wishes to leave that money and possessions – their estate –that they have accumulated over their life to the family that survives them? This transfer of an estate in the United States is subject to what is called an Estate Tax. This tax is alternatively known as the inheritance tax or more morbidly as the “death” tax.

Estate Tax Calculation Examples

Let’s look at a simple example to illustrate the basics of Estate Tax. In our scenario, I have a net worth of two million dollars and I die. My will stipulates that I will leave my entire estate to my son. My son stands to inherit two million dollars from me – does he have to pay taxes on the inheritance of my two-million-dollar estate? In this instance, the answer is that he will not have to pay taxes on his inheritance. The current tax exclusion amount for an estate is 5.49 million dollars (2017). This means that if the net worth of my estate is 5.49 million dollars or below – as it is in this example and in fact for the majority of Americans – then my heirs will inherit the full amount of my estate without having to pay taxes.

Tax Calculation for Estates Above the Exemption

What happens however if my net worth is over the 5.49-million-dollar exemption? Let’s suppose that my net worth at my death is 10 million dollars and I again wish to leave the amount to my son. What is the tax requirement to be paid on this inheritance?

To calculate the tax on this amount we would take 5.45 million and subtract it from 10 million.

10,000,000 – 5,490,000 = 4.51million

The rate the 4.51 million would be taxed at is 40% (again for 2017).

4.51 million x 40 % = $1,804,000

So, the federal government keeps $1,804,000 leaving my son with a net of $8,156,000 ($2,706,000 plus 5.45 million tax free) million dollars.

Estate Tax and Married Couples

My above example was for an individual dying and passing the estate on. What if I were married? Then we could calculate the Estate Tax using a joint exemption – the exemption would then be 11 million dollars! In this example, let’s say I’m married and my wife and I jointly have a 7-million-dollar estate that we leave to our son.  Because we have the 10-million-dollar tax free exemption our son would get the entire 7 million without paying taxes on it.

How to Reduce Estate Taxes

While the above illustrates the basics of Estate Tax – it is in reality a little more complex. For instance, there are annual exemptions that can be taken – such as annual gift giving – that can allow for unlimited amounts that are tax free. For most people the 5.49 million exemption will have them covered, but if you were fortunate and have this first world problem of too much money then there is a way to avoid some of these taxes for your heirs.

In 2017, the gift limit that someone can receive from you without it counting against your lifetime exclusion amount is $14,000. So each year you can gift as many people as you like $14,000. So, if I had more money than I intended in retirement and suspected my death was approaching I would gift $14,000 each year to each of my kids, their wives or husbands, my grandkids, and maybe even other relatives depending on how much I wanted to avoid estate taxes. Remember the estate taxes is at 40% so doing this saves your family and friends $5,600 on each gift you make.

State Estate Taxes

Lastly some states impose estate taxes and it is wise to pay close attention to the rules that govern such taxes in your state. Their exemptions and rates are often very different than that of the federal government.

Argument for The Estate Tax

Let’s say an individual builds a large company and has a net worth of 10 Billion and passes it all on to his or her one child. This child could then passively make money off this money and have it grow over their lifespan to 30 billion. If there are not enough offspring to split this estate then the money will rapidly grow through investments without the family doing anything. What would happen over time is this family would control a greater portion of the nation’s wealth without having to do anything. So, a nobility class becomes formed. This is what makes America different from old Europe. Winston Churchill believed estate taxes were a corrective measure against the race of the idle rich.

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