What it is:
How it works/Example:
An estate tax is often levied on the assets that the deceased leaves to his or her heirs.
However, in most other cases, non-spouse beneficiaries will be required to pay taxes on the deceased's taxable estate. Typically, estate taxes are only levied once a certain threshold, known as the exclusion limit, has been reached. Currently, the exclusion limit is $5 million at the federal tax level (state tax levels vary).
Let's look at an example. Assume that John has $10 million in various investment accounts. He also owns a house worth $1.8 million that still has an $800,000 mortgage. He is not married, and he's already set aside $20,000 in a designated account to pay for his funeral expenses.
Now assume that John dies unexpectedly in a car accident, and his assets pass to his only son, Sam.
John's estate, after deducting the costs of his funeral and the repayment of his debts, is taxable. The IRS includes cash, securities, real estate, insurance, trusts, annuities, businesses, farms and other assets when calculating John's taxable estate.
We can use this information to calculate John's taxable estate:
$10,000,000 + 1,800,000 - $800,000 - $20,000 -$5,000,000 = $5,980,000
John's estate must pay estate taxes on the $5,980,000 value of the estate that is left over after accounting for John's debts and the IRS exclusion limit. Some states also assess their own estate taxes on top of this.
The executor of John's estate is responsible for ensuring that the taxes are paid.
Why it matters:
Estate taxes are some of the most complicated kinds of taxes. In general, when assets flow to a spouse rather than an heir, a "marital deduction" applies, which makes most assets exempt from estate taxes. Similarly, assets donated to charity are generally not subject to estate taxes. Last, but not least, is the federal estate tax exemption of $5 million (scheduled to expire at the end of 2012).
Estate taxes, like other taxes on unearned incomes, are a source of revenue for governments that use it to finance various projects. The issue of the estate tax has become highly politicized, and it is sometimes referred to as the "death tax" by people who oppose it.
But estate taxes are not inevitable. In the U.S., there are many different estate planning techniques that individuals can use to reduce the size of their taxable estates.