In order to pass on your wealth to your chosen beneficiaries at death, in addition to probate and other estate settlement costs, you (or more correctly, your estate) may have to pay death taxes at the federal level, and possibly also at the state level.
Death taxes come in two main varieties: estate taxes and inheritance taxes. The federal government and the following twenty-four states currently have estate taxes which tax the estate before it is distributed: Connecticut, District of Columbia, Illinois, Indiana, Iowa, Kansas, Kentucky, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Ohio, Oklahoma, Oregon, Pennsylvania, Rhode Island, Tennessee, Utah, Vermont, Virginia, Washington and Wisconsin. The following eleven states impose an inheritance tax: Indiana, Iowa, Kansas, Kentucky, Louisiana, Maryland, Nebraska, New Jersey, Oregon, Pennsylvania, and Tennessee.
You should be aware that most of the states impose what is sometimes called a "pick-up" estate tax, the calculation of which is based on the federal taxable estate. Because the federal taxable estate is determined after a deduction for state death taxes paid, the two calculations are intertwined. Although there are variations in these "pick-up" taxes, it is generally designed so that the state tax is limited to an amount no larger than necessary to reduce federal estate tax to $0. So, if a person's federal taxable estate, prior to a deduction for state death tax, is at a level that doesn't result in a federal estate tax liability, then the person shouldn't have a liability under a state pick-up tax. In effect, the state pick-up tax takes an amount that would otherwise be paid for federal estate tax.
Federal estate tax. We will focus here on the federal estate tax for two reasons: (1) it is potentially applicable to you no matter where you live, and (2) its rates are significantly higher (18 to 45 percent through 2009) than that other tax that we all love to hate, the income tax (with its 10 to 35 percent rates for individuals through 2010). Note that we have a very awkward situation in 2010. The estate tax rate went down to zero as of January 1, 2010, and we still don't know what Congress is going to do about it. If Congress does nothing, there is no estate tax in 2010, but, for the beneficiaries in 2010, there may be greater income tax implications.
Actually, although there is a separate federal estate tax, tax liability is computed on the basis of what is called the federal unified transfer tax. The unified transfer tax is made up of three distinct, but closely related, taxes: the estate tax, the gift tax and the generation skipping transfer (GST) tax. Both the federal gift tax and the GST tax have their own sets of rules and planning strategies, but for purposes of this discussion, we'll only briefly introduce them and point out their main purpose: to prevent avoidance of the estate tax. Without the gift and GST taxes, individuals — particularly wealthy individuals — could get out of paying the estate tax by making lifetime transfers.
The unified transfer tax is computed with reference to the value of the property that is considered to be in your gross estate at death, plus the value of taxable gifts that you made during your life. Generally, if the total of your lifetime taxable gifts and the value of the property that you own as of the date of your death exceeds $3.5 million for 2009, a estate tax liability may be owed on the excess value. And if this tax applies, it will be steep: the tax rate will be 45 percent!
Under current law, while the estate tax has been repealed for one year in 2010, it will rise from the ashes bigger and stronger in 2011--in the same form and with the same rates up to 55 percent and exclusion of only $1 million that existed in 2001. However, much is uncertain, as the law is expected to be changed during 2010. Most expect the tax to be resurrected sometime during 2010; many expect it to be made retroactive to January 1, 2010.
But, back on point. Even if your gross estate exceeds the limit for exclusion from estate tax, all is not lost! There are many deductions and strategies available to reduce or eliminate the estate tax liability. Here's what you need to consider: