Understanding the Federal Estate Tax
There’s a recurring theme that comes up in many of my new client intake meetings; something that causes people a great deal of concern: the estate tax. I can understand why it’s on so many peoples’ minds. Given how much we hear about the estate tax in the news media and from politicians on both sides of the aisle, you might assume that it impacts nearly everyone. However, in recent years, fewer than one in one thousand estates have been subject to the federal estate tax. So in this month’s article, I thought it would be helpful to provide a quick look at the basics of the estate tax so that readers can get a better sense of how it works and whether it might impact them. If the estate tax is something you’d like to discuss in greater detail, I encourage you to schedule a free initial consultation to discuss your estate planning needs.
Gift Tax Basics – A Prerequisite to Understanding the Estate Tax
To understand how the estate tax works, it is necessary to understand a bit about the gift tax, too. This brief overview of the gift tax only addresses the gift tax exemption as it relates to the estate tax exemption. A more in-depth discussion addressing the annual exclusion, gift splitting, and other topics will have to wait for a future blog post.
Certain gifts are known as “taxable gifts” and are subject to the gift tax. The tax code says each person has a $10 million exemption from the gift tax, and the exemption amount gets adjusted each year for inflation. In 2024, the gift tax exemption amount is set at $13.61 million. When a person makes a taxable gift, they can file a gift tax return which tells the IRS to utilize the person’s gift tax exemption amount to shelter the taxable gift from tax. If the person has gift tax exemption equal to or exceeding the amount of the taxable gift, then no tax is owed as a result of making the gift. However, the person will have less gift tax exemption remaining to shelter future gifts from the gift tax.
As an example, assume an individual named Mike has not made any taxable gifts in his lifetime, and so he has all of his $13.61 million gift tax exemption available to him. In 2024, Mike makes a taxable gift in the amount of $2 million. After making the gift, Mike files a gift tax return which notifies the IRS of the gift and tells the IRS to apply $2 million of Mike’s gift tax exemption to the gift, fully sheltering it from the gift tax. Going forward, Mike’s available gift tax exemption will be reduced by $2 million.
The Estate Tax
When a person dies, they get to take advantage of another important exemption: the estate tax exemption. Like the gift tax exemption, the estate tax exemption is set at $10 million and is adjusted each year for inflation, currently sitting at $13.61 million. If a person dies with an estate worth less than their available estate tax exemption (after taking any available deductions), then the estate is entirely sheltered from the estate tax. The estate and gift tax exemptions are linked together and are known as the “unified credit,” because utilizing gift tax exemption during life reduces the amount of estate tax exemption available at death. Another example will help to illustrate the interaction between these two exemptions.
Let’s revisit our friend Mike from the previous example. As we saw before, Mike made his first ever taxable gift in the amount of $2 million in 2024. This left him with $11.61 million in remaining gift tax exemption. Later in 2024, Mike died. At the time of his death, Mike had an estate worth $13 million. Had Mike not made any taxable gifts during his lifetime, his full $13.61 million estate tax exemption would have been available to shelter his entire estate from the estate tax. But because Mike used $2 million of his gift tax exemption during his lifetime, his estate tax exemption is reduced by the same amount. Mike only has $11.61 million in estate tax exemption available, and so $1.39 million of Mike’s $13 million estate will be subject to the estate tax (but the $11.61 million covered by his remaining estate tax exemption will not be subject to any estate tax).
If an individual’s estate exceeds their available estate tax exemption (similar to Mike’s estate above), they will have to pay the estate tax on the amount that exceeds their available estate tax exemption. Mike’s estate exceed his remaining estate tax exemption by $1.39 million, and only this $1.39 million is subject to tax. Assets subject to the estate tax are taxed at a rate of 40%. In Mikes case, his estate would owe $556,000 — a little over 4% of the value of his $13 million estate.
If a married person dies and has any estate tax exemption amount remaining, they can leave the unused exemption to their surviving spouse to be used to shelter the spouse’s estate from tax when the spouse eventually dies. The spouse gets the benefit of this leftover exemption amount in addition to their own $13.61 estate tax exemption (reduced by any taxable gifts the spouse has made). As another benefit to married couples, a married person’s estate may deduct the value of all assets transferred to the surviving spouse as a result of the deceased’s death. This combination of the marital deduction plus the ability to leave any unused exemption to the surviving spouse is a powerful one, allowing a married couple to potentially shelter a combined $27.22 million from the estate tax under 2024’s exemption amount.
Consider one more example. Once again, we have Mike who made a $2 million gift early in 2024 and died later that same year with an estate worth $13 million. If Mike left his entire estate to his surviving spouse, then Mike can deduct all $13 million on his estate tax return and owe no tax. This means Mike did not need to use his remaining $11.61 million estate tax exemption, and so he can give this unused exemption to his wife. Mike’s wife will now have her own $13.61 million estate tax exemption plus the $11.61 million she received from Mike, allowing her to shelter a total of $25.22 million in assets from the estate tax at her death.
IMPORTANT: The Estate Tax Exemption is Scheduled to be Cut in Half in 2026
In the previous sections of this article, I’ve said that the estate and gift tax exemption amounts are set at $10 million with adjustments for inflation. That is true until the end of 2025. The exemption amounts are scheduled to be reduced by half starting in 2026, meaning the baseline exemption amount will be $5 million with adjustments for inflation. This reduction will result in a return to way the law read prior to the Tax Cuts and Jobs Act of 2017. Congress could act to extend the life of the $10 million exemption amount, but this is not guaranteed, and taxpayers need to be prepared for the possibility that a much lower estate tax exemption could apply to their estates if they die on or after January 1, 2026.
Can the Estate Tax Be Avoided?
If an individual is concerned that they will owe the estate tax upon their death, there are planning techniques that can be implemented to reduce or eliminate their estate tax exposure. These techniques are somewhat complex, and a full explanation of their workings is beyond the scope of this article. Many of them involve transferring assets into trusts known as “irrevocable trusts” which get the assets out of the individual’s taxable estate but preserve the assets’ ability to provide for the taxpayer’s beneficiaries. However, the individual who establishes the irrevocable trust generally cannot retain any interest in the property transferred to the irrevocable trust and also must give up a significant amount of control over the trust assets. Irrevocable trusts will also be responsible for paying annual income taxes and filing annual tax returns, which results in additional costs. Individuals must therefore weigh the impact of the estate tax against the expense, complexity, and sacrifice involved in avoiding it. Before making any decisions about utilizing irrevocable trusts (or other techniques) to reduce estate tax exposure, individuals should consult with their team of legal, financial, and tax advisors to make sure the pros and cons of such planning are fully understood.
The Bottom Line
While the estate tax can cost some estates a great deal of money, it is not a cause for concern for most individuals, especially in 2024 and 2025 when the exemption amount is so high ($13.61 million in 2024). Taxpayers should, however, be prepared in the event the exemption amount gets cut in half in 2026. For those who are likely to face an estate tax problem and want to take action, there are techniques that can reduce or eliminate estate tax exposure, but these techniques should be given careful consideration, as they generally involve a loss of control over property and introduce new costs and administrative responsibilities where there were none before.
If you have questions about the estate tax or anything else related to your estate plan, I hope you will get in touch to schedule a free consultation. Initial consultations can be conducted in person or by Zoom, and estate planning work is done on a convenient flat fee basis.
The information contained in this blog post is intended only as general legal information and should not be construed as formal legal advice on any matter, nor should its presentation be construed as intent on the part of The Law Office of Ryan A. Layton, PLLC to form an attorney-client relationship with any user of this website. For more information, please see this disclaimer.