federal estate tax
Fees applied to any assets that are left to a beneficiary when someone passes away.
Federal Estate Tax Details
The Internal Revenue Service (IRS) determines federal estate taxes based on the estate's fair market value instead of the deceased's original amount. Unfortunately, that means the estate will be taxed more since the value increased over time. However, it does protect you from being taxed on the peak value of the assets.
For the tax year of 2021, the IRS stated that estates must file a federal estate tax return and pay the taxable amount on any estate that exceeds $11.7 million combined gross assets and prior taxable gifts. The IRS will tax anything above $11.7 million at the rate of 40%. However, there are discounts, deductions, and loopholes that can reduce the tax amount owed. The IRS website has a table showing the different rates and tax amounts for different ranges.
Anything left to a living spouse is not subject to the estate tax. But when that spouse passes away, then the federal estate tax kicks in. Some things are also not taxed, like charitable donations.
Example of Federal Estate Tax
The IRS taxes estates on the fair market value, not the original purchase value or peak amount. For example, if you purchased a house at $7 million, and later the house passed to a beneficiary and is valued at $5 million, the IRS will tax the house based on the $5 million value.
Another example is Jane and John are married and build up an estate valued at $3 million. In their affairs, Jane names John as her first beneficiary, and their daughter Susan will inherit after John passes. Jane passes away; this means that John will not have to pay federal estate taxes because he is a surviving spouse. Several years later, John passes away, and Susan inherits; Susan then has to pay the federal estate tax because she is not a surviving spouse.
Significance of Federal Estate Tax
Sometimes the federal estate tax can seem like a significant burden to the one inheriting. One way to seriously reduce the amount of estate that can be taxed is to keep things simple. You can do this by setting up trusts to help transfer the wealth and keep it taxed.
There is an Intentionally Defective Grantor Trust (IDGT). This trust allows the trustor to isolate certain assets and keep income tax and estate tax separated on those assets. The trustor would pay income tax on revenue generated by the asset, and it can increase without the IRS tacking on additional taxes.
Life insurance policies can also help reduce the federal estate tax amount. Most of the time, money coming from a life insurance policy is not taxed, But if you include the money in your taxable estate for estate tax purposes, then it is taxed. One way to prevent that is by transferring ownership of the policy to another person or entity or setting up an Irrevocable Insurance Trust (ILIT).