After you die, the federal government-and, in some cases, your state government-may tax the value of the assets you've left behind. Known as the estate, or inheritance, tax, this amount is deducted from your estate, with the remaining assets going to your designated heirs. The executor of the estate calculates and pays the tax, often with help from a knowledgeable accountant or attorney.
Calculating your estate
Everything you own outright, or own an interest in, is accounted for upon your death. The estate is assessed and the fair market value of your assets used to calculate the estate's size. Then the amount of your estate's expenses—items such as funeral costs, mortgage or other loan payments, and estate-administration costs—are deducted, along with any charitable donations you have instructed your estate to make. The final result is the net estate, which is then distributed to your heirs.
If your estate's total net value is over $1 million, generally the estate executor will need to file an estate or inheritance tax return, known as form 706, with the IRS within nine months of the date of death. (A six-month extension can be obtained if requested prior to the due date, but estimated taxes may still be required by the nine-month deadline.) The executor may also need to file a return if your estate contains assets that are difficult to value, such as fine art or a business.
Paying estate or inheritance tax is rare: currently, only about 2 percent of all estates have to pay estate tax. Through 2009, estates under $2 million in total size were excluded from the estate tax, but note this cutoff is subject to change. Exclusion caps from 2008 to 2011 are as follows (subject to change):
- 2008: $2 million
- 2009: $3.5 million
- 2010: Repealed
- 2011: $1 million
If you fail to pay estate tax owed, the IRS or your state government may impose additional fines or charge you interest on the overdue tax. The IRS may also seize assets to obtain the tax money owed.
Reducing your estate
If you want to reduce or eliminate the federal tax your estate will pay upon your death, some lawyers suggest doing so by reducing the size of your estate during your lifetime by making annual gifts to your heirs. In 2007, you could give cash or other assets valued at $12,000 tax-free to each child or other heir; married couples could give $24,000 to each heir. After your death, the total amount you gifted during your lifetime will be added to the value of the remaining estate to figure the estate's total size for tax purposes.
You can also reduce the size of your estate by donating money or other assets to charities. Reducing your estate during your lifetime is considered advisable by some, as the estate tax rate can be steep: as high as 45 percent in recent years.
State estate taxes
Some states collect estate or inheritance taxes of their own, at various tax rates. Tax rates vary depending on the size of the estate, as well as by how closely related heirs were to the deceased. If your estate pays state estate tax, that amount will be deducted from the federal tax owed.
Click here to see a list of all the states that collect an estate or inheritance tax of some kind; contact your state's department of revenue for details on your state's estate tax law.