An estate tax exemption works differently for married couples and for heirs, as married couples have a special exemption and strictly speaking the estate tax only affects heirs. When both members of a couple die, the executor or administrator of their estate must file an estate tax return disclosing the amount of the estate's assets. If the assets exceed the exemption amount as defined by the Internal Revenue Service, the heirs are responsible for paying tax.
Estate Tax Definition And Purpose
The estate tax is an extension of the gift tax, which prevents wealthy individuals from passing assets to others without paying any tax. Typically, only a few percentage of American households are subject to the estate tax, and an exemption is granted to estates with assets below an annually-determined amount.
Estate Tax History
For 2009, estates less than $3.5 million were not required to pay any estate tax, while those above this limit paid tax at rates of up to 55 percent. In early 2010, the estate tax was allowed to lapse and was scheduled to return in 2011 for estates of just $1 million or more in assets.
Spousal Deduction
Regardless of the level of the estate tax exemption, spouses are able to pass an unlimited amount of property between them upon death with no tax consequences. Thus, even a $100 million estate can pass tax-free from one spouse to another upon death.
Estate Planning And Trusts
A fundamental estate planning strategy is to set up a trust known as a bypass or A-B trust. The purpose of this trust is to accept the full amount of one spouse's estate tax exemption upon death, with the balance passing to the surviving spouse. Although the details of the tax law governing this transfer are complicated, essentially this allows the surviving spouse to preserve the deceased spouse's full estate tax exemption, effectively doubling the amount that can pass to heirs tax-free.
Income and Capital Gains Taxes
Although estates under the exemption level may pass to heirs estate-tax free, other taxes may still be incurred by heirs. For example, if an Individual Retirement Account (IRA) passes from a decedent to a non-spousal heir, that IRA must be distributed over a period of years determined by the IRS. The income drawn from inherited IRAs is taxed at ordinary income tax rates. In addition, capital gains taxes may be owed on inherited assets that have appreciated in value. While assets traditionally receive a "step-up" in cost basis at death, this provision elapsed in 2010, meaning heirs must treat inherited property as if it was purchased at the decedent's original cost. Any difference between the sales price and this original cost would be taxed at capital gains rates.
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