This is part 2 of our two-part explanation on how the federal estate tax works. Part 1 is available here.

Congress decides the federal estate tax

It is up to Congress to decide the inheritance exemption amount and tax rate. On January 1, 2013 Congress passed the American Taxpayer Relief Act (ATRA), which exempts taxes on estates up to $5 million, adjusting each year for inflation. ATRA was a “permanent” law established by Congress; however, they can, have, and will change the law in the future. Below are the historical exemptions and tax rates:

2010: A good year to die (and be rich!)

As depicted in the chart above, there were no federal estate taxes in 2010, the first time since 1916! Due to lack of action by Congress, there was an unplanned gap in estate taxes. No matter how large of an estate someone passed on in 2010, the federal government did not collect estate taxes. Thus, it was a good year to die for the wealthy.

It was also a good year for Yankees fans. By dying in 2010, long time New York Yankees owner George Steinbrenner saved his heirs a lot of money. Had he died in 2009, his estate could have faced federal taxes up to $500 million, depending on how the estate was structured. Instead, Steinbrenner’s heirs, who are the current owners of the Yankees, benefited tremendously.

Federal estate tax

For 2014, a 40 percent tax rate will be applied to any estate over $5.34 million per individual (married couples can combine their exemptions to give away $10.68 million). For example, if you are inheriting an estate worth $8.34 million, then $3 million of that estate will be taxed by the feds. Since the estate tax rate is 40 percent, the estate will pay $1.2 million (40 percent tax rate x $3 million taxable estate) to the federal government. After taxes, the beneficiary will have inherited a total of $7.14 million ($8.34 million estate – $1.2 million in taxes). This means the estate would have paid an effective tax rate of 14.4 percent ($1.2 million in taxes / $8.34 million estate).

As the value of the estate increases, the effective tax rate will approach the 40 percent maximum estate tax rate. For example, if you are inheriting $1 billion dollars, the entire inheritance, minus the $5.34 million exemption, is taxed at 40 percent. The effective tax rate will be around 39.79 percent ($397.8 million in taxes / $1 billion estate).

Note that if you have an estate large enough to exceed the exemption amount, there are likely a number of estate planning opportunities available to you to lower or eliminate your estate’s tax bill after you pass away. Please contact us to discuss your options.

Pros of the federal estate tax

  • Provides substantial revenue for the U.S. government.
  • Promotes the distribution of wealth. There is a widening gap between the rich and poor that the estate tax can mitigate.
  • Promotes charity, as the estate tax doesn’t apply to charitable contributions.
  • Less than 1 percent of decedents dying each year will be subject to the tax.
  • Inherited wealth may cause beneficiaries to become unproductive members of society.

Cons of the federal estate tax

  • Penalizes people for having financial success since only amounts greater than $5.34 million are taxed.
  • Double taxation. Money that has already been taxed as income is again taxed when inherited.
  • Harmful to family owned businesses and farms because the heirs will have less working capital and may have to sell off assets or land to pay the tax.
  • Revenue from the federal estate tax accounts for less than 1 percent of tax revenue raised per year, and the administrative costs of collecting the tax partially offsets the revenue raised from the estate tax.
  • Estates that may be subject to the estate tax spend significant money in estate planning in order to minimize the tax burden.