Estate Planning Basics: Understanding the Federal Estate Tax (the "Death Tax")

   The Federal Estate Tax, commonly referred to as the "Death Tax," is one of the most controversial and misunderstood federal taxes.  Although some form of tax assessed upon the death of an individual goes as far back as 1862, the modern version of the Federal Estate Tax was created in 1916.  The term "death tax" was first used in the 1940's, and has been frequently used since then by opponents of the tax.

What is the Federal Estate Tax?
   The Federal Estate Tax is officially defined as a tax on your right to transfer property at your death. To put it another way, it is a tax assessed on the value of your estate at the time of your death.  When calculating the amount of the tax, the first step is to determine the value of the decedent's (the person who died) gross estate.  The gross estate is the fair market value of everything the decedent owned or had an interest in (such as a business) at the time of death.  Certain deductions are then allowed (such as a mortgage or other qualifying debts) to determine the decedent's net estate.  From the net estate, taxable gifts are added back in to reach the taxable estate.*

What is the amount of the tax in 2013?   
   Much of the confusion over the Federal Estate Tax is due to the frequent changes to the tax rate and the amount of the exemption.  To eliminate such changes in the future, on January 1, 2013, Congress passed, and President Obama signed into law, the Taxpayer Relief Act of 2012, which set the Federal Estate Tax exemption at $5,000,000 for a single person who died in 2012, with a tax rate of 40% on estates that exceeded the exemption.  The exemption is indexed for inflation each year, so the exemption for 2013 is $5,250,000.

   As an example, if a single person dies in 2013 with a Taxable Estate of $7,000,000, the first $5,250,000 is not taxed due to the exemption.  So, the amount of the estate subject to the tax is $1,750,000.  Based on a tax rate of 40%, this person's estate will pay Federal Estate Taxes of $700,000 (1,750,000 * .4).

   The other new feature introduced in 2012 is that the exemption for a married couple is twice the exemption for a single person, and the surviving spouse can use the previously deceased spouse's unused exemption.

   As an example, let's assume that Joe and Susan are married.  Joe dies in 2013, and at that time the couple's taxable estate is $4,000,000 (We'll assume for this example that this couple owns everything jointly).  Joe's estate will use $4,000,000 of his possible $5,250,000 exemption, so his estate will not be subject to tax.  Susan now becomes the sole owner of the entire estate.  Several years later, Susan dies at a time her taxable estate is $8,000,000.  For purposes of this example, we'll assume that the exemption is now $6,000,000.  So, at the time Joe died, he had $1,250,000 of unused Federal Estate Tax exemption.  Susan can use that unused exemption, plus her own $6,000,000 exemption, for a total exemption of $7,250,000. Since her taxable estate is $8,000,000, she will pay taxes on $750,000 (8,000,000 - 7,250,000); if the tax rate is still 40%, her estate will pay Federal Estate Taxes of $300,000 (750,000 * .4).

How does this impact me?  Will my estate have to pay the Federal Estate Tax when I die?
   As mentioned above, the estate of a single person who dies in 2013 will only pay the Federal Estate Tax if the estate is worth more than $5,250,000.  The estate of a married couple has a total exemption of $10,500,000 in 2013.  It is estimated that less than one-tenth of one percent of estates will now be subject to the Federal Estate Tax.

My estate most likely won't be subject to the Federal Estate Tax - do I still need a will or trust?
   Although not everyone needs an estate plan, there are several reasons besides tax avoidance to have a will or trust.  Among the top reasons:
1) You have minor children and you want to provide for guardianship of your children in the event you die before your children reach age 18.
2) You own assets, and you want to decide, instead of allowing a court to decide, who will inherit your assets upon your death.
3) You want your estate to avoid the costs of probate administration.
4) You want to hold property in trust for use by future generations.
    

*Please note that determining the Taxable Estate can be very complicated and is beyond the scope of this article.

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