Estate taxes: Who pays, how much and when

Benjamin Franklin famously noted that only two things are certain: death and taxes. An estate tax combines them both. Sometimes referred to as a “death tax,” this federal tax is levied on the transfer of assets once an individual passes away. 

How does estate tax work?

Imagine that at death, all the assets you own or have an interest in are captured in a snapshot. Regardless of where they’re located, those assets make up your gross estate for federal estate tax purposes.

In 2023, the Internal Revenue Service (IRS) levied a federal estate tax on individuals having assets with a fair market value of $12.92 million or greater at their death. The IRS considers estate assets to be any interest in real estate, such as a home. Other examples of assets include, but are not limited to:

• Stocks and bonds
• Cash
• Interest in life insurance or annuity contracts
• A 401(k) or other retirement accounts
• Personal property, such as a vehicle, clothing or household furnishings

If the decedent’s estate plan leaves their assets to their spouse, an estate tax may not be due. An unlimited marital deduction allows an unrestricted transfer of assets between spouses. However, any assets owned by the surviving spouse at their time of death will be included in their taxable estate, including previously exempted amounts. If the surviving spouse has remarried and leaves assets to their surviving spouse, those qualified assets along with any assets distributed to a qualified charitable organization may pass free of estate tax.

How much is estate tax?

Current federal estate tax rates put in place in 2017 by the Tax Cuts and Jobs Act (TCJA) range from 18% to 40%. However, both the tax rates and estate tax exemption amounts are scheduled to "sunset" at the end of 2025, reverting to pre-TCJA levels. The estate tax exemption will drop from $12.92 million per individual to an estimated $6.8 million (adjusted for inflation), and the maximum gift and estate tax rate will increase from 40% to 45%.

The new rules will reduce the amount that an individual could pass on tax free, says Jessica Aycock, managing director for estate settlement services at U.S. Bank. As a result, now is a good time to make plans to transfer wealth to heirs and charities.

Are there state estate taxes, too?

In addition to federal estate tax, your assets may be subject to state estate tax if you reside in a state that imposes this tax. Keep in mind that your assets could be subject to state estate tax even if your estate isn’t worth the current federal estate tax filing limit of $12.92 million at the time of your death. 

Currently, 12 states and the District of Columbia charge estate taxes, which are paid in addition to any federal estate tax. The exemption levels vary and range from $1 million to $9.1 million. The state estate tax is generally charged based on the state an individual resides in at the time of their death. However, other factors, such as owning physical assets outside of your home state, could give rise to additional state estate tax liability.

When are estate taxes paid?

Federal and state estate taxes are paid from the assets of your estate before the remaining assets can be distributed to your heirs. The executor or the trustee of a qualified grantor trust is responsible for filing the applicable federal and state estate tax returns and ensuring that all taxes are paid from estate. After confirming no additional liabilities exist, the executor or trustee will distribute the remaining assets to the named beneficiaries.

The federal estate tax return, Form 706, is due nine months from the decedent’s date of death and can be extended an additional six months. If an estate tax payment is due, the estate tax payment should be made on or before the original filing deadline for the return unless a request for an extension to pay has been granted by the IRS.

“It’s important to understand that the IRS can take up to three years to let an executor or trustee know whether they have accepted the return as filed or if they will audit the return,” says Aycock. “An audit of the estate tax return may result in additional estate taxes being assessed. It’s not uncommon for several years to have passed before the executor or trustee receives a final assessment from the IRS.”

What’s the difference between estate tax and inheritance tax?

An inheritance tax is another type of death tax and is paid by the beneficiary, not the estate. It’s charged at the state level and is assessed by the state a person resides at the time of their death. Currently, just six states levy an inheritance tax. Maryland is the only state that charges both an estate tax and an inheritance tax.

“Inheritance tax is often based off the relationship of the deceased to the person receiving the assets,” says Aycock. “Beneficiaries who are closer to the deceased, such as a spouse or children, tend to pay a lower tax rate than someone who's more distant, like a friend or a cousin four times removed.”

Gift tax vs. estate tax

Each year, individuals can make a gift up to the annual gift tax exclusion limit, without having to pay gift tax or file a federal gift tax return. The limit in 2023 is $17,000 per recipient. Amounts above this cap are considered taxable gifts and must be reported on a gift tax return, which is due the following calendar year.

Gift tax does not apply in certain circumstances, including:

• Qualified gifts made to your spouse, contributions to a political organization or to a qualified charitable organization
• Qualified medical or education expenses paid directly to the educational or medical provider

How to reduce estate taxes

High net worth individuals subject to estate taxes can take steps to minimize their tax burden. “Making annual gifts within the annual gift tax exclusion amount to reduce your overall estate value is one way,” says Aycock.

Here are some other options for reducing estate taxes to discuss with your wealth advisor:

• Leave funds to charity. An estate planning attorney could draft a plan that eliminates or reduces estate taxes by giving the amount above what can be sheltered from estate tax to a qualified charity. Outright gifts to charities may be eligible for the unlimited charitable deduction and can allow you to fulfill both your philanthropic goals as well as to minimize estate taxes.
• Set up an irrevocable trust. You can establish an irrevocable trust for others during your lifetime. While you will relinquish control of the assets and pay gift taxes on your contribution to the trust, the assets will be outside of your estate and any income or appreciation will go the named beneficiaries. You can also make lifetime gifts into an intentionally defective irrevocable trust. In this situation, the individual who sets up the trust, or grantor, pays income taxes on any revenue generated by the assets, ensuring that trust assets are not used to pay taxes and enhancing the growth potential of the trust assets.
• Use an irrevocable life insurance trust (ILIT) policy. You can establish a trust that will own an insurance policy on your life. You’ll make contributions to the trust periodically. The trust uses those funds to pay premiums on the insurance policy and, at death, the proceeds are exempt from estate taxes as long as the trustee adheres to all the requirements that the IRS has in place during the lifetime of that trust.
• Pay for educational or medical expenses from the estate. These distributions are exempt from annual exclusion gift tax requirements only if the funds go directly to the provider.

If your net worth is nearing or over the current estate tax threshold, either for federal or state taxes, working with a wealth advisor can help you learn about strategies to minimize your tax burden.

“Most people don't like paying taxes,” says Aycock. “Using the current tax laws, a CPA, attorney and financial advisor can help guide you to accomplish what you want to do with your assets. 

“You worked hard to earn what you have. You need a robust team to make sure you leave as much as possible to future generations.”

Learn about trust and estate services at U.S. Bank.