Understanding Estate Tax and How to Calculate It
The federal estate tax is a tax on the transfer of your property at death. Often called the "death tax," it only affects estates worth more than the federal exemption amount, which has been historically high in recent years due to the Tax Cuts and Jobs Act (TCJA). Understanding how estate tax works and planning accordingly can help you maximize what you pass to your heirs and minimize tax burden.
What is Estate Tax?
Estate tax is a federal tax imposed on the net value of a deceased person's estate before distribution to heirs. The estate includes all assets owned at death: real estate, investments, bank accounts, business interests, retirement accounts, life insurance, personal property, and more. The tax is paid by the estate itself, not by the beneficiaries who inherit the assets.
It's important to distinguish estate tax from inheritance tax. Estate tax is levied on the estate before assets are distributed, while inheritance tax (imposed by some states) is paid by the beneficiaries who receive the assets. The federal government does not have an inheritance tax, only an estate tax.
Federal Estate Tax Exemption Explained
The federal estate tax exemption is the amount below which no estate tax is owed. This exemption has changed significantly over the years and is currently at historic highs due to the Tax Cuts and Jobs Act of 2017. For 2024, the exemption is $13.61 million per individual, meaning estates worth less than this amount owe no federal estate tax.
The exemption is indexed for inflation, so it increases slightly each year. For 2025, it's estimated at approximately $13.99 million, and for 2026, approximately $14.2 million. However, these high exemption levels are temporary. Unless Congress acts to extend the TCJA provisions, the exemption is scheduled to sunset at the end of 2025, reverting to approximately $7 million per person (adjusted for inflation) beginning in 2027.
This impending sunset creates urgency for estate planning, especially for individuals with estates between $7 million and $14 million, who may face significant estate taxes if they pass away after 2026 without proper planning.
How Estate Tax is Calculated
Calculating estate tax involves several steps:
- Determine Gross Estate: Add up the fair market value of all assets owned at death, including real estate, investments, business interests, bank accounts, retirement accounts, life insurance, vehicles, jewelry, art, and other personal property.
- Subtract Allowable Deductions: Reduce the gross estate by deductible amounts including debts and mortgages, funeral and estate administration expenses, property passing to a surviving spouse (unlimited marital deduction), and charitable bequests to qualified organizations.
- Calculate Taxable Estate: The result after deductions is your taxable estate. From this, subtract any adjusted taxable gifts made during your lifetime that used your estate tax exemption.
- Apply Exemption: Subtract the federal estate tax exemption for the year of death. Any amount remaining is subject to estate tax.
- Calculate Tax: The federal estate tax rate is a flat 40% on the amount exceeding the exemption. Additionally, check if your state imposes an estate tax, which would be calculated separately.
For example, if someone dies in 2025 with a gross estate of $20 million, debts of $2 million, and funeral expenses of $50,000, the calculation would be: Gross Estate ($20M) - Deductions ($2.05M) = Adjusted Gross Estate ($17.95M). Subtracting the 2025 exemption of $13.99M leaves $3.96M subject to tax. At 40%, the federal estate tax would be approximately $1.58 million.
Estate Tax vs Inheritance Tax
While often confused, estate tax and inheritance tax are fundamentally different. Estate tax is assessed on the entire estate before distribution, paid from the estate's assets, and based on the total value of the estate. The federal government and some states impose estate taxes.
Inheritance tax, by contrast, is paid by individual beneficiaries on the assets they receive, can vary based on the beneficiary's relationship to the deceased, and is only imposed by a handful of states (Iowa, Kentucky, Maryland, Nebraska, New Jersey, and Pennsylvania). The federal government does not have an inheritance tax.
Some beneficiaries in certain states may face both estate tax (reducing the overall estate) and inheritance tax (on what they receive). Maryland is unique in imposing both an estate tax and an inheritance tax, though the inheritance tax only applies to non-relatives.
Who Actually Pays Estate Tax?
Despite common misconceptions, very few estates actually owe federal estate tax. With the current exemption at nearly $14 million per individual, only the wealthiest 0.1% of estates are subject to federal estate tax. For married couples, portability allows the surviving spouse to use any unused exemption from the deceased spouse, effectively creating a combined exemption of nearly $28 million.
However, this will change significantly if the TCJA sunsets as scheduled. With the exemption reverting to approximately $7 million per person, many more estates will be subject to estate tax beginning in 2027. This affects small business owners, farmers, and individuals with significant real estate holdings who may not consider themselves wealthy but have substantial asset values.
Portability for Married Couples
Portability is a valuable provision that allows a surviving spouse to use any unused estate tax exemption from their deceased spouse. This effectively allows married couples to shield up to twice the individual exemption amount from estate tax.
For example, if a husband dies in 2025 leaving $5 million to his children, he uses $5 million of his $13.99 million exemption, leaving $8.99 million unused. If his widow files an estate tax return electing portability, she can add this $8.99 million to her own exemption, giving her a total exemption of approximately $22.98 million.
To claim portability, the executor must file Form 706 (estate tax return) even if no tax is due, and must make the portability election within nine months of death (or 15 months with an extension). Failing to file this return means losing the ability to port the unused exemption, which could cost heirs millions in unnecessary estate taxes.
State Estate Taxes Overview
While most states don't impose estate taxes, twelve states and the District of Columbia do. These state exemptions are generally much lower than the federal exemption, meaning you might owe state estate tax even if you don't owe federal tax.
State estate tax exemptions vary widely. Massachusetts and Oregon have the lowest exemptions at $2 million and $1 million respectively, while Connecticut's exemption matches the federal exemption at $13 million. States with estate taxes include: Connecticut ($13M exemption), Hawaii ($5.49M), Illinois ($4M), Maryland ($5M), Massachusetts ($2M), Minnesota ($3M), New York ($6.94M), Oregon ($1M), Rhode Island ($1.73M), Vermont ($5M), Washington ($2.193M), and Washington D.C. ($4M).
Some states also have "cliff" provisions where exceeding the exemption by even $1 can subject the entire estate to tax, not just the amount over the exemption. New York and Massachusetts, for instance, have such provisions, making careful planning especially important in these states.
Estate Tax Deductions
Several deductions can significantly reduce your taxable estate. The unlimited marital deduction allows you to leave any amount to your U.S. citizen surviving spouse free of estate tax, though this merely defers tax until the surviving spouse's death. For non-citizen spouses, special rules apply, and a Qualified Domestic Trust (QDOT) may be necessary.
The charitable deduction is unlimited for amounts left to qualified charitable organizations, making charitable giving an effective estate tax reduction strategy. Debts owed at death, including mortgages, loans, and credit card balances, are fully deductible.
Funeral expenses and costs of administering the estate (executor fees, attorney fees, court costs, appraisal fees) are also deductible. State death taxes paid can be claimed as a deduction on the federal return. Casualty and theft losses during estate administration may also be deductible.
The TCJA Sunset Provision
The Tax Cuts and Jobs Act of 2017 temporarily doubled the estate tax exemption through 2025. Unless Congress acts to extend these provisions, the exemption will automatically revert to its pre-TCJA level (approximately $5 million, adjusted for inflation to roughly $7 million) on January 1, 2027.
This sunset creates a unique planning opportunity. Individuals with estates between $7 million and $14 million should consider making large gifts before the end of 2025 to take advantage of the higher exemption. The IRS has confirmed that these gifts will not be "clawed back" if the exemption decreases, making this a use-it-or-lose-it opportunity.
However, gifting strategies must be carefully considered. Gifts don't receive a step-up in basis at death, meaning beneficiaries inherit your cost basis and may face higher capital gains taxes when they sell. For highly appreciated assets, it may be better to hold them until death to get the step-up in basis, even if it means paying estate tax.
Estate Planning Strategies to Reduce Tax
Numerous strategies can help reduce or eliminate estate tax:
Lifetime Gifting: You can give up to $18,000 per person per year (2024) without using any of your lifetime exemption or filing a gift tax return. For a couple, this doubles to $36,000 per recipient. Over time, this can remove substantial assets from your estate. Larger gifts use your lifetime exemption, which is unified with the estate tax exemption.
Irrevocable Life Insurance Trusts (ILITs): Life insurance proceeds are included in your taxable estate if you own the policy at death. Transferring ownership to an ILIT removes the proceeds from your estate while providing tax-free liquidity to pay estate taxes or provide for heirs.
Grantor Retained Annuity Trusts (GRATs): You transfer appreciating assets to a trust, receive annuity payments for a term of years, and at the end of the term, remaining assets pass to beneficiaries gift-tax-free. This works especially well for assets expected to appreciate significantly.
Qualified Personal Residence Trusts (QPRTs): Transfer your home to an irrevocable trust while retaining the right to live there for a specified term. After the term, the home passes to beneficiaries, removed from your estate at a discounted value.
Charitable Remainder Trusts (CRTs): You receive income for life or a term of years, then the remainder passes to charity. You get an immediate charitable deduction and remove assets from your estate.
Family Limited Partnerships (FLPs): Transfer assets to a partnership and gift limited partnership interests to family members at discounted values due to lack of control and marketability, reducing your taxable estate while maintaining management control.
Spousal Lifetime Access Trusts (SLATs): One spouse creates an irrevocable trust for the benefit of the other spouse and children, removing assets from both estates while maintaining indirect access through the beneficiary spouse.
Stepped-Up Basis Benefits
One significant benefit of holding appreciated assets until death is the step-up in basis. When you inherit property, your cost basis is "stepped up" to the fair market value on the date of death. This eliminates all capital gains tax on appreciation that occurred during the decedent's lifetime.
For example, if your parent bought stock for $100,000 that's now worth $1 million, inheriting it gives you a $1 million basis. You could sell immediately with no capital gains tax. However, if they gifted it during life, you'd inherit their $100,000 basis and owe capital gains tax on the $900,000 appreciation when you sell.
This makes the decision to gift versus hold assets until death complex. For estates well below the exemption amount, holding appreciated assets until death is often better to get the step-up in basis. For estates subject to estate tax, gifting may be preferable despite losing the step-up, since the 40% estate tax rate often exceeds the capital gains tax rate.
Example Estate Tax Calculations
Example 1 - No Estate Tax: Sarah dies in 2025 with a gross estate of $8 million. After deducting debts ($500,000) and funeral expenses ($25,000), her taxable estate is $7,475,000. This is well below the $13.99 million exemption, so no federal estate tax is owed. Her heirs receive the full $7,475,000 (minus state estate tax if applicable).
Example 2 - Estate Tax Due: Michael dies in 2025 with a gross estate of $25 million. After deductions of $1 million, his taxable estate is $24 million. Subtracting the exemption of $13.99 million leaves $10.01 million subject to tax. Federal estate tax at 40% is $4,004,000. If he lives in New York, additional state estate tax would apply. His heirs receive approximately $20 million after federal tax.
Example 3 - Portability: John dies in 2024 leaving $6 million to his children. His widow elects portability, adding his unused exemption ($13.61M - $6M = $7.61M) to her own exemption of $13.99M (2025 amount), giving her a total exemption of $21.6M. When she dies in 2025 with an estate of $18 million, she owes no federal estate tax.
Example 4 - Sunset Impact: Jennifer's estate is worth $10 million. If she dies in 2026, with the exemption at $14.2M, she owes no tax. If she dies in 2027 after the sunset, with the exemption at approximately $7M, her estate would owe approximately $1.2 million in federal estate tax ($10M - $7M = $3M × 40%).
When to Consult an Estate Attorney
While this calculator provides estimates, estate planning is complex and mistakes can be costly. You should consult an experienced estate planning attorney if your estate exceeds or approaches the exemption amount, you own a business that represents a significant portion of your estate, you have children from multiple marriages, you own property in multiple states, or you have a non-citizen spouse.
Additionally, seek professional advice if you're considering making large gifts before the 2025 sunset, want to establish trusts or other estate planning vehicles, have concerns about estate liquidity, or need to coordinate estate tax planning with income tax and gift tax planning.
An estate planning attorney can help you navigate complex rules, implement advanced strategies, ensure documents are properly drafted, coordinate with your financial and tax advisors, and provide peace of mind that your estate plan will accomplish your goals while minimizing tax.
Estate tax planning is not just for the ultra-wealthy. With the impending sunset of the TCJA provisions, many more families will face estate tax starting in 2027. Proactive planning now can save your heirs hundreds of thousands or even millions of dollars in unnecessary taxes while ensuring your legacy passes according to your wishes.