How Does The Death Tax Work?

When someone passes, or when someone is considering creating their estate plan, many times the question “how does the ‘death tax’ work?” comes up in conversation. This is an understandable concern, as most people want to keep as many of their assets within their control as possible, instead of paying unnecessary taxes.

So how does the “death tax” work, and how does it affect your estate planning?

The world of taxes is technical and complicated, but hang in there. We will try to make things as simple as we can. The first thing you need to know is that there is not just one “death tax” that you need to think about.  What is commonly thought of as the “death tax” is actually made up of several taxes:

There are three main types of taxes that affect estate planning: estate tax, income tax, and capital gains tax.

Estate Tax

This is generally what people think of first when they are wondering how the “death tax” works. In reality, only the very wealthy in the U.S. are affected by the estate tax. However, that has not always been the case, and it could change at any time.

Here is the basic concept of the estate tax:

At the end of your life, the government will look at what you’ve given away during your lifetime, as well as what you’re gifting to your heirs. If those two categories combined equal more than about $10,000,000.00 for a single person (the actual amount is a bit higher and increases each year), or about $20,000,000.00 for a couple, a tax of around 40% will be applied to any amount OVER those amounts. The actual amounts and percentages vary slightly depending on the situation, but these figures are a good rule of thumb.

If you’re in a position where you think estate tax could apply to you, consult an expert about how to set up a proper plan for reducing the amount your heirs will owe in estate taxes.

Also, if you have received an inheritance and you owe estate taxes, you also need to make sure you don’t run afoul of the related generation-skipping tax.

Income Tax

Unlike the estate tax, which taxes gifts you give, the income tax taxes what you earn. You are probably much more familiar with this tax than you want to be.

Like a living person, an estate can earn money if it owns certain investments or a business. But more frequently, estates owe income taxes because they contain tax-deferred funds such as retirement accounts.

Tax-deferred Funds

Income invested in certain retirement accounts (like a 401k or IRA) is untaxed, so when it’s time to pull that money out and use it, you (or your beneficiary, if you’re gone) must pay income taxes on it.

This kind of money is referred to as “tax-deferred funds”. People who inherit tax-deferred funds have various options about how and when they must pay the taxes owed on those funds.

What you need to know is that how these funds are inherited determines how many options your beneficiary has.

If you want your loved ones to have the greatest flexibility in dealing with the income taxes owed on tax-deferred funds, you should use a beneficiary designation to transfer those funds, and not a trust or a will. If you pass tax-deferred funds through a trust or will, the person who receives them will have fewer options about how the income taxes must be paid.

Funds Earned By Your Estate

Your estate or trust also has the potential to continue earning income after you die. This could be interest earned on a checking account, the sale of certain investments, or income from a business.

And income always means taxes, whether you’re dead or alive.

The most important thing to keep in mind about this kind of income is that an estate or trust is taxed at the highest tax rate much more quickly than an individual. For example, right now, an individual will only pay the highest income tax rate (currently 37%) if they earn $500,000 or more annually. However, a trust or estate will pay that same tax rate if it earns $12,750 or more.

The easiest way to avoid these increased income taxes is to set your estate plan up to distribute your assets quickly after your death.

Capital Gains Tax

Capital gains taxes are taxes on the money you gain through investments. If you buy a $50 stock in Starbucks, and later sell it for $100, the government will tax you on that $50 increase.
Here’s how this type of death tax works:

Capital gains taxes at the time of your death are impacted by a rule called a “step-up in basis”. Step-up in basis is a great rule; it simply means that whoever inherits your assets will only owe capital gains on the increase in value after you died. Any amounts the investments increased in value before you died are not taxed!

For example, go back to your Starbucks stock. You bought it for $50, and let’s say you pass away without selling it. If it’s worth $150 when you die, that is its new basis under the step-up in basis rule. Now let’s say that your daughter inherits the stock, hangs on to it for a year, then sells it for $175. Instead of having to pay taxes on the difference between the original $50 and $175 (which is what you would have had to pay if you still owned it), she’ll only have to pay taxes on the difference between $150 and $175. She gets a substantial tax break.

For this reason, you want to think carefully before selling or giving away investments that have appreciated in value if there is a chance you can pass them on to your heirs. The step-up in basis rule can make a difference in the amount of capital gains taxes that are owed.

Let a Professional Help

As we said, taxes can get complicated. They can also get expensive. Mark Twain once facetiously said,

The only difference between a tax man and a taxidermist is that the taxidermist leaves the skin.

Funny, but it can be all too true. While it’s not the most enjoyable thing to think about how death taxes work, everyone should understand the basics and ensure that their hard-earned money is used to achieve their goals, not to pay unnecessary taxes.

We have given you an aerial view of how the “death tax” works in the form of principles that can help you. But because of how complicated taxes get depending upon your financial situation, it’s always wise to consult an accountant or a tax expert to get specific advice about how to reduce the amount of taxes you will owe.


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Joshua E. Hummer, Esq. is a licensed attorney who has been admitted in both Virginia and West Virginia. He is a graduate of the University of Virginia and has been practicing for over 15 years. While experienced in many parts of the law, Josh specializes in estate planning, estate administration, and elder law.