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The estate tax in the United States is a federal tax on the transfer of the estate of a person who dies. It is charged to a decedent’s estate when their assets pass on to their beneficiaries. Currently, most estates won’t trigger the federal estate tax, as it only applies to estates worth more than $11.7 million in 2021. Because this tax can have a significant effect on your beneficiaries, it’s best to plan ahead for it in your estate plan.

Important Things to Know About Estate Taxes in the USA

Federal estate taxes apply to only a small fraction of taxpayers. But even if you don’t have to pay federal estate taxes, you may be on the hook for state taxes.

The Federal Estate Tax System: Basic Structure

The federal estate tax is actually part of a larger system of taxation called the federal transfer tax system, made up of:

  1. The estate tax, which covers transfers of property at death.
  2. The gift tax covers transfers of property during a person’s lifetime.
  3. The generation-skipping transfer (GST) tax covers transfers of property to people who are one or more generations younger.

What’s Included in an Estate?

In a word, almost everything. Many assets are straightforward: for example, your investment accounts, bank accounts, residence, other real estate, equity in a business, the cash value of an insurance policy, and personal property. However, other assets are a bit vaguer. For example, the following are also included in an estate:

  1. A life insurance policy on the life of another person that you own.
  2. A life insurance policy on your own life if you own the policy or if you have an incident of ownership (the ability to exercise an economic right)
  3. A life insurance policy on your own life if ownership was transferred within the three years preceding your death.
  4. Property held in joint tenancy
  5. Any property over which you have power of appointment (the authority to determine who will enjoy or own the property)
  6. The present value of a pension, retirement benefit, or annuity if there are survivorship benefits
  7. Any property in which you have a retained life interest (the right to use the property under certain conditions), even if you transferred it to someone else before your death
  8. Any property that you revocably transferred before your death (with the right to reclaim it)

Which States Have an Estate Tax?

Several states and the District of Columbia have an estate tax. Many have lower asset thresholds than the federal government. Each state’s exclusion amount is listed in the table below.

If you live in a state with an estate tax, the good news is that your estate tax bill is subtracted from the value of your taxable estate before you calculate what you might owe the IRS.

Large Loopholes Enable Many Estates to Avoid Taxes

Many wealthy estates employ teams of lawyers and accountants to develop and exploit loopholes in the estate tax that allow them to pass on large portions of their estates tax-free.  These strategies don’t benefit the broader economy; they only allow the wealthiest estates to avoid taxes.

Married Couples Get a Break

It wasn’t very long ago that married couples had to set up bypass trusts (also known as AB trusts or credit shelter trusts) to take advantage of each other’s estate tax exclusions. This has changed because of portability, a relatively new provision that allows a surviving spouse to add any unused portion of a deceased spouse’s exclusion to her or his own exclusion. In other words, in 2022, a married couple can pass on up to $24.12 million to their heirs free of federal estate tax without a trust or any extra planning.

Different Rules for a Noncitizen Spouse

The federal government doesn’t want someone who isn’t a U.S. citizen to inherit a large amount of money, pay no estate or gift tax, and then return to his or her native country. Therefore, if your spouse isn’t a U.S. citizen, you may not be able to transfer your assets to him or her tax-free.

Nonetheless, you can leave assets worth up to the exclusion ($12.06 million for deaths in 2022) to anyone, including your noncitizen spouse, without owing any federal estate tax. If the noncitizen spouse dies first, assets left to the spouse who is a U.S. citizen do qualify for the unlimited marital deduction.

If your estate exceeds this limit, you can also set up a qualified domestic trust (QDOT), which can postpone payment of estate taxes until after your noncitizen spouse dies.

Inheritance Tax vs. State Estate Tax

Estate taxes are based on the value of the deceased person’s estate, no matter who receives it.

Inheritance taxes vary depending not only on the amount being transferred but also on the relationship between the deceased and the beneficiary. In most states, the closer the relationship, the lower the rate. A spouse will pay the least, a minor child will pay more, an adult child or parent will pay more still, and a brother or sister will pay even more. Nonrelatives will pay the most.

How to Reduce or Avoid the Federal Estate Tax

If you want to reduce your estate taxes before you die, there are some tactics you might use to protect your property. They include:

  • Spending your assets: If you’re not afraid of running out of money before you die, enjoy your wealth.
  • Spreading your assets: You could give away part of your estate as gifts to loved ones while you’re still around. Many states don’t tax gifts.
  • Giving away your assets: If you leave property to a qualifying charity, it is deductible from the gross estate.
  • Shielding your assets in a trust: Properly created irrevocable trusts could provide a way to legally shelter some of your assets from state and federal estate taxes.
  • Moving to a more favorable tax environment: Since most states don’t have an estate tax or an inheritance tax, you have many relocation options.

Finances can be daunting, but the team at South Star Wealth Management makes it far less so. Whether you have significant assets to manage or if you are just starting to accumulate wealth, we have the tools and background to provide the services that may fit your needs. For a comprehensive review of your personal situation though, always consult with a tax or legal Advisor; neither Cetera Investment Services nor any of its representatives may give legal or tax advice. Curious how we can help you? Contact us today to schedule an appointment!