Is there any regulation that has a more sinister name than the death tax? What could possibly be worse than a tax on something that we can't control? The very name "death tax" conjures up images of grieving family members at the mercy of greedy tax collectors, heartless bureaucrats who line their pockets with the hard-earned wealth of the dead.
Thankfully, it's all a myth.
The term "death tax" is simply that: a term used to frighten taxpayers and motivate legislators to alter the tax laws. And while there are taxes that federal and state governments levy on the wealth that a person transfers to others upon death, the governments don't simply charge taxpayers for dying.
The taxes that most often fall under the death tax moniker can be complex and confusing, however. To separate fact from fiction, let's look at some of the most common myths about the taxes collectively referred to as the death tax.
Although tax-reduction advocates frequently use the term "death tax," there is no state or federal tax that's officially called by this name. The term actually refers to a pair of taxes levied by the government: the estate tax and the inheritance, or gift, tax [source: IRS].
These taxes have been around in various forms since the era of Roman emperors. Taxes on the transfer of wealth, as gifts or inheritance, were often instituted to help nations pay for wars or other major unexpected events that threatened fiscal integrity. In many cases, these taxes were repealed after the war or event ended [source: Jacobson].
In the United States, estate taxes were first used to help finance wars in the late 1700s. The estate tax reappeared during other times of conflict into the 1800s. The tax became a formal, non-war-related tax later, when the federal government passed the Revenue Act of 1916 [source: Jacobson]. The taxation rates, exemptions and other details have changed drastically since then, but the taxes have never officially been called death taxes. Likewise, the Internal Revenue Service (IRS) doesn't charge taxpayers a fee simply for dying, as the name "death tax" might imply [source: IRS].
Taxpayers sometimes confuse estate taxes with inheritance taxes, or lump both taxes under the term "death tax." While both taxes concern the transfer of wealth to others, each focuses on specific types of wealth transfers.
The estate tax taxes your right to transfer your property to others when you die. If you amassed a fortune in your lifetime, or collected a significant gallery of fine art, it stands to reason that you should have the right to decide which relatives, friends or organizations receive your wealth when you die. The state can't simply come in and take these items just because you're no longer around to protect them [source: Jacobson].
Inheritance taxes, or gift taxes, are slightly different. These are taxes on gifts you give another person, where you receive nothing (or something of much lower monetary value) in return [source: IRS]. The transfer of wealth doesn't have to be an actual gift for it to qualify for this tax; the recipient simply has to receive much less in return for it.
One hotly debated aspect of the so-called death tax is the lifetime limit on property transfers that's exempt from taxation. The federal government allows taxpayers to transfer a certain amount of wealth, either during their lives or after death, before it starts taxing those gifts.
Throughout this century, the protected lifetime amount has increased, from $1 million in 2001 to $3.5 million in 2009. But the Tax Act of 2001 included a clause that would revert this exemption back to $1 million at the end of 2010 (more on this later) [source: Schwab].
The exemption amounts may seem like tremendously high sums. After all, who has a million U.S. dollars or more to give away? But remember: This is a lifetime amount. Combine the value of a person's real estate, possessions and investments, and the amount of property that person's heirs stand to inherit, and it can easily approach the limit. Add to that the gifts the person may give during his or her lifetime to charities, family members, alumni associations and other organizations, and it's easy to imagine even a middle-income person hitting the exemption cap.
The Web sites of anti-tax advocacy groups offer up a range of stories about families who have lost farms, businesses and generations-old family estates because of the high burden of estate taxes [sources: Policy and Taxation Group, American Family Business Institute]. If a family member transfers your family business through a gift or inheritance without proper planning, the resulting taxes could make it difficult for your family to keep the business intact.
Part of the problem can arise when a person's estate, especially business or land holdings, isn't properly valued before death. For example, a family farm in an area where suburban development has swallowed other farms may maintain a lower taxable value than its surroundings while the farmer is alive and working the land. But when the farmer dies, the land could be reappraised at a much higher taxable value, since the land around it has been converted into housing tracts. The farm, in the eyes of the tax appraisers, is now very valuable land that's not being put to its best use. In this situation, the heirs to the farm may not be able to afford the increased tax burden.
Avoiding this type of situation requires early and thorough planning. If you have an estate you wish to give to heirs, and if that estate exceeds the IRS's exemption limit, you should consult an experienced tax attorney, accountant or financial planner.
Inheritance and estate taxes are like most other taxes, in that there are both state and federal versions. In much the same way that you must file separate state and federal income taxes every year, you may face similar -- but slightly different -- tax situations when paying federal and state inheritance and estate taxes.
Since each state has the right to set its own taxes, estate and inheritance taxes vary. Some states base their exempted amounts, tax rates, and filing and payment procedures on those of the federal government [source: Oregon Department of Revenue]. Others base parts of their inheritance tax structure on market factors [source: Combs].
If you have a substantial estate and are thinking about moving to another state, it can pay to investigate various states' tax structures. Some, due to the vagaries of state legislation, may offer you a better financial scenario than others. A tax advisor familiar with estate planning issues in the state of your choosing can help you understand the nuances of the state tax code. While this isn't likely to be the deciding factor in where you choose to move or retire, it's valuable information to have on hand as you plan for the future of your estate [source: Retirement Living Information Center].
The very nature of estate and inheritance taxes -- that they're paid out of your estate, or by your heirs, after your death -- may make them seem like something completely out of your control. However, leaving the problem for your heirs to work out is not only inconsiderate; it can also add unnecessary costs to your material and financial legacy. It pays to make moves during your lifetime that can protect your estate for your heirs.
One target of inheritance and estate taxes is the income you'd earn if you were still living. This is often in the form of investments and retirement accounts, and they're taxable in much the same way as they'd be if you were alive. If your spouse is living, one very effective way to minimize this tax is to plan for a spousal transfer of assets. Not only does this help you provide for your spouse's income after you die, but it also means inheritance taxes can be postponed until after your spouse's death [source: Mayerhoff].
Likewise, giving gifts of assets during your lifetime can help minimize costs to your heirs if those gifts would be more heavily taxed after your death. Regardless of your state, type of asset or financial situation, passing on your assets during your lifetime requires forethought and planning to ensure you divest the right assets to the right recipients at the right time to minimize tax burden [source: Mayerhoff].
Any tax law can be complex and confusing. Many people who stand to leave behind a sizeable estate protect their wealth by seeking the advice of a tax attorney or accountant familiar with estate and inheritance tax issues. While this is a smart financial move if you don't have the time or resources to investigate tax law on your own, there are resources available that can help you complete some -- if not all -- of the tax-planning steps you should take to protect your estate from being overtaxed.
The IRS makes publicly available all of the tax filing forms you would need to manage estate or inheritance taxes [source: IRS]. The agency also provides helpful brochures on the basics of estate and inheritance tax planning [source: IRS].
Even if you plan to hire an attorney or accountant to help you, you'd be wise to do some basic research to familiarize yourself with the taxes. At the very least, you need to determine if your estate will exceed the lifetime exemption amounts. This can help you ensure that the tax professional who helps you does not over-prepare your tax plan (and possibly charge you for more services than you need) [source: Money-Zine.com].
With all of the debate among federal legislators over taxation and tax rates, one might assume that the federal estate and inheritance taxes have disappeared. The federal estate tax has been a topic of heated conversation in the first part of the 21st century, but efforts to eliminate it haven't been successful. What has happened, however, is a series of changes that affect who pays how much tax.
A series of tax cuts implemented by the federal government in 2001 were set to expire at the end of 2010. For estate taxes, that would have meant a reversion to a fixed exemption amount of $1 million, which would not increase annually to reflect inflation, and a maximum tax rate of 55 percent on estates. Essentially, a large number of previously exempt estates would suddenly face a tax rate that, if not handled properly, could have cost more than half of the amount inherited [source: Pacific Life].
But in late 2010, Congress passed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, also known as the 2010 Tax Act. This act capped the top estate tax rate at 35 percent and provided for $5 million per taxpayer in estate tax exemption [source: Herpe]. The act didn't do away with inheritance or estate taxes, but it improved the picture for many taxpayers who will receive inheritances this year.
Modern tax laws are complex. The labyrinth of requirements, exemption amounts and deductions can make even the simplest personal tax filing a complicated affair. It's no wonder that a large part of the accounting industry's work involves filing taxes or preparing tax documents in anticipation of future filing.
Any tax filing mistake can sting because of the amount of money involved. Adding the recent death of a loved one and concerns over inherited wealth to the mix only makes the matter more complicated and stressful. But despite the confusion and difficulty in navigating the tax code, the estate and inheritance tax processes are not inherently rigged in the IRS's favor.
Consider the amount of documentation available to taxpayers on the IRS's Web sites. These documents, with their long names and identification codes, may seem like a different language; however, they provide enough information for a knowledgeable person to complete nearly any complex tax filing. The IRS also provides brochures on specific filing procedures, including estate taxes [source: IRS]. With this information freely available to any taxpayer with computer access, it's hard to make the case that the IRS is intentionally trying to confuse or trick estate heirs.
This is a self-defeating myth for two reasons.
First, the 2010 Tax Act limited the maximum estate tax, which is imposed on the largest estates, to 35 percent. That can be a sizeable amount of wealth to pay to the government, but it's far less than the 55 percent maximum that the new tax law prevented [source: Herpe].
Second, the entirety of a granter's estate doesn't necessarily have to be taxed through the estate tax. If the estate is small enough (equal to or less than $5 million per taxpayer in 2011), it receives an exemption from the IRS. This allows many taxpayers to avoid the estate tax. Furthermore, gifts to charitable organizations, retirement accounts left to spouses and wealth transferred to family as a gift all fall under individual nuances of the tax code. They may be taxed differently and at different times. By planning the divestment of your estate to include these items, you may be able to reduce significantly the burden on your heirs [source: Mayerhoff].
For more information on the death tax and related taxes, check out the links on the next page.
The most sweeping tax overhaul in decades became law in December 2017. HowStuffWorks explains what taxpayers can do to benefit from the tax changes.
- American Family and Business Institute. "What is the Death Tax?" 2009. (Jan. 20, 2011)http://www.nodeathtax.org/deathtax
- Combs, Susan. "Texas Taxes: Inheritance Tax." Window on State Government. (Jan. 22, 2011) http://www.window.state.tx.us/taxinfo/inherit/
- Herpe, David A. et al. "Wealth Transfer Planning Considerations for 2011 and 2012." McDermott Will & Emery. Jan. 20, 2011. (Jan. 22, 2011) http://www.mwe.com/index.cfm/fuseaction/publications.nldetail/object_id/9e8952ff-a1f5-4fa8-99bb-f5e9a9b9f266.cfm
- IRS. "Estate and Gift Taxes." June 22, 2010. (Jan. 11, 2011) http://www.irs.gov/businesses/small/article/0,,id=98968,00.html
- IRS. "Forms and Publications." Jan. 21, 2011. (Jan. 22, 2011) http://www.irs.gov/formspubs/index.html
- IRS. "Introduction to Estate and Gift Taxes." Dec. 14, 2009. (Jan 22, 2011)http://www.irs.gov/pub/irs-pdf/p950.pdf
- Jacobson, Darien B. et al. "The Estate Tax: Ninety Years and Counting." IRS. June 18, 2008. (Jan. 11, 2011)www.irs.gov/pub/irs-soi/ninetyestate.pdf
- Mayerhoff, Gerald L. "Giving Foundation: Minimizing the Inherited Income Tax." Baptist Health South Florida. Feb. 6, 2004. (Jan. 22, 2011)http://www.baptisthealth.net/en/giving/Pages/Minimizing-the-Inherited-IncomeTax.aspx
- Money-Zine.com. "Federal Inheritance Tax." (Jan. 22, 2011) http://www.money-zine.com/Financial-Planning/Tax-Shelter/Federal-Inheritance-Tax/
- Oregon Department of Revenue. "Inheritance Tax." Oregon.gov. Aug. 31, 2010. (Jan. 22, 2011)http://www.oregon.gov/DOR/BUS/inher-general.shtml
- Pacific Life. "Estate Tax Exemption Amount." December 2010. (Jan. 22, 2010) http://www.pacificlife.com/Channel/Educational+Information/Estate+Planning+Concepts/Estate+Tax+Exemption+Amount.htm
- Policy and Taxation Group. "Horror Stories & Articles." 2009. (Jan. 20, 2011)http://www.policyandtaxationgroup.com/html/stories.html
- Retirement Living Information Center. "Taxes by State." January 2011. (Jan. 22, 2011)
- Schwab, Carol A. "Planning Your Estate: Estate and Gift Taxes." North Carolina Bar Association. October 2001. (Jan. 19, 2011) http://www.ncbar.org/download/planningYourEstate/taxes.html