The federal estate tax exemption is the amount of an individual’s estate that is exempt from federal estate tax upon their death. Estates valued below this exemption amount are not subject to the federal estate tax, while any value above the exemption is taxed at a federal estate tax rate, which can go up to 40%. The exemption is part of the federal estate tax system designed to tax the transfer of wealth upon death, but only for estates above a certain size.
Here’s a breakdown of how the federal estate tax exemption works:
1. Exemption Amount
- As of 2023, the federal estate tax exemption is $12.92 million per person. This means that an individual can pass up to $12.92 million to heirs without any federal estate tax being levied.
- For married couples, the exemption doubles because of portability (explained below), allowing them to pass up to $25.84 million tax-free.
2. Portability for Married Couples
- The federal estate tax exemption is portable between spouses. This means that if the first spouse dies and does not use all of their exemption, the surviving spouse can inherit the unused portion of the deceased spouse’s exemption.
- For example, if a spouse dies and only uses $5 million of their $12.92 million exemption, the surviving spouse can “inherit” the remaining $7.92 million and add it to their own exemption, giving the surviving spouse a total exemption of $20.84 million ($12.92 million + $7.92 million).
- To take advantage of portability, the executor of the first spouse’s estate must file an estate tax return (Form 706), even if no estate tax is due, to claim the unused exemption for the surviving spouse.
3. Taxable Amount of Estate
- The estate is valued at the time of death, including all property such as:
- Real estate
- Bank accounts
- Investments (stocks, bonds, etc.)
- Business interests
- Personal property (jewelry, art, etc.)
- Life insurance policies (if the deceased owned the policy)
- Retirement accounts (like 401(k)s and IRAs)
- Any value above the exemption amount is subject to federal estate tax at rates ranging from 18% to 40%, depending on the amount over the exemption.
4. Unlimited Marital Deduction
- You can leave an unlimited amount of money and assets to your surviving spouse without triggering any estate tax, due to the unlimited marital deduction. This applies as long as the spouse is a U.S. citizen.
- This means that if you leave everything to your spouse, no federal estate tax will be due when the first spouse dies, regardless of the size of the estate. However, when the surviving spouse dies, the estate will be taxed unless it is below the exemption limit.
5. Gift Tax and Lifetime Exemption
- The federal estate tax exemption is linked to the lifetime gift tax exemption. The total amount of gifts you make during your lifetime counts against the estate tax exemption.
- For example, if you make lifetime gifts exceeding the annual exclusion amount (currently $17,000 per person per year in 2023), those gifts are deducted from your estate tax exemption. So, if you use $2 million of your exemption for lifetime gifts, your estate will only have $10.92 million of exemption remaining upon your death.
- Lifetime gifts are tracked via gift tax returns (Form 709), which are filed annually.
6. Annual Gift Exclusion
- The annual gift exclusion allows you to give up to $17,000 per person (as of 2023) each year without affecting your estate tax exemption. Gifts under this exclusion are not subject to gift tax and do not count against your lifetime exemption.
- Married couples can gift up to $34,000 per recipient each year by “splitting gifts.”
7. Tax Rates on Amounts Above the Exemption
- Any portion of an estate that exceeds the federal estate tax exemption is taxed at rates ranging from 18% to 40%. The top rate of 40% applies to estates that exceed the exemption by large amounts.
8. Changes to the Exemption
- The federal estate tax exemption is subject to change. The current high exemption of $12.92 million per person is set to sunset after 2025, returning to approximately $5 million (adjusted for inflation) unless new legislation is passed. This could significantly affect estate planning strategies for individuals with large estates.
9. Deductions that Reduce the Estate’s Value
- Certain deductions can reduce the value of the estate subject to taxation, including:
- Funeral expenses
- Administrative expenses related to settling the estate
- Debts owed by the decedent
- Charitable donations made through the estate
Example:
- Single Estate: If you die in 2023 with an estate worth $15 million, $12.92 million is exempt from federal estate tax, leaving $2.08 million taxable. The taxable amount would be subject to the estate tax, with rates ranging from 18% to 40% on the taxable portion.
- Married Couple: A married couple with a combined estate of $30 million could pass up to $25.84 million tax-free if they utilize both exemptions. The remaining $4.16 million would be subject to federal estate tax.
Conclusion:
The federal estate tax exemption allows you to pass a significant amount of wealth to your heirs without incurring federal estate tax. However, for estates that exceed the exemption, tax planning is critical to minimize the tax burden on your beneficiaries. By using strategies like gifting, trusts, and the unlimited marital deduction, you can effectively manage estate tax liabilities and preserve more wealth for your heirs. Consulting with an estate planning attorney is essential to ensure that your estate plan takes full advantage of the current exemption and prepares for potential changes in the law.