How the Estate Tax Works

Who Pays the Estate Tax?

Under 2012 tax law, the Internal Revenue Service (IRS) requires the executor of an estate valued at more than $5 million to file an estate tax return (Form 706, if you're curious) within nine months of a person's death. That $5 million exclusion threshold was set by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, but the exclusion hasn't always been so high.

In 1940, estates valued at $40,000 or more were subject to estate tax, and even as recently as 2000, an estate worth more than $675,000 owed estate taxes [source: Jacobson et al]. The Bush-era tax cuts chipped away at the estate tax, gradually increasing the estate tax exclusion from 2001 through 2009 -- to a high of $3.5 million -- before repealing the estate tax entirely in 2010. The current $5 million exclusion was the result of a hard-fought compromise between legislators who wanted to kill the estate tax for good and those who argued its importance for paying down the national debt.

Because the exclusion threshold has changed significantly over the years, the estate tax has affected different segments of the U.S. population. When the exclusion was lower, a broader population was subject to the tax, including middle-class households that had invested wisely and saved a significant nest egg. From 2001 to 2010, as the threshold continuously increased, the number of estate tax returns filed dropped from 108,000 to 15,000 [source: Internal Revenue Service]. In its current form, the estate tax affects only the wealthiest Americans. According to research by the Urban-Brookings Tax Policy Center:

  • The top 0.1 percent of income earners pay 51.2 percent of estate taxes.
  • The top 1 percent of earners pay 78.4 percent of estate taxes.
  • The top 10 percent of earners pay 98.2 percent of estate taxes, leaving the other 90 percent of Americans to pay 1.8 percent of estate taxes [source: Tax Policy Center].

To put those percentages into perspective, the Tax Policy Center estimates that only 8,600 Americans of the 2.5 million who died in 2011 will leave estates with a gross value over $5 million [source: Tax Policy Center]. But that doesn't mean that each of those 8,600 estates will actually owe money in federal estate tax. The tax code allows for a number of significant deductions and credits, lowering the taxable net value of the estate below $5 million.

One of the biggest deductions is for charitable contributions. According to Internal Revenue Service (IRS) statistics, an average of 24 percent of estates valued at $1 million or more left money to charitable institutions like religious organizations, educational institutions and other non-profits. Of that 24 percent of estates, each gave away an average of 20 percent of its total assets [source: Jacobson et al]. Other deductions that lower the taxable value of the estate are: any assets that are passed on to a surviving spouse; unpaid debts at the time of death; funeral expenses; any estate or inheritance taxes paid to state governments.

When the Tax Policy Center factors in the number and monetary value of all of these deductions, it estimates that only 3,300 of the 8,600 estates with a gross value of more than $5 million will pay estate taxes in 2011. With a marginal tax rate of 35 percent, those 3,300 estates will pay an estimated total of $10 billion in estate taxes [source: Tax Policy Center].

Speaking of tax rates, what's the difference between the marginal estate tax rate and the effective rate? We'll take a closer look on the next page.