How Your Estate Tax is Computed
The starting point for your estate tax liability is your gross estate. In a nutshell, you take stock of all your assets and determine how much they are worth to come up with your gross estate. From your gross estate, you subtract the allowable deductions to come up with your net estate which is what will be subject to tax.
The following deductions can be made to your gross estate:
From this net estate, you then subtract the federal estate tax exemption—$5.25 million for 2013—to arrive at what is known as your “taxable estate.”
Let’s make the estate tax liability a bit clearer by giving an example: Let’s say that your gross estate is valued at $7,000,000. The allowable deductions and expenses are pegged at $700,000. The taxable estate is: $7,000,000 – $700,000 = $6,300,000. From this, you subtract the federal estate tax exemption of $5,250,000 and you arrive at your taxable estate which is $1,050,000, provided that you have not made any lifetime gifts. Since the estate tax rate is 40 percent, you then multiply $1,050,000 by 40% to come up with your estate tax liability. In this case, your tax liability is $420,000.
Because the estate tax and the gift tax are unified in the United States tax code, a discussion of the estate tax is not complete without looking at the gift tax. Normally, any gift you give to others is subject to tax. But federal law is so structured so as to allow you to give gifts that do not exceed a certain amount per year without getting taxed.
For 2013, you can gift up to $14,000 ($28,000 for married couples) without having to worry about any gift tax issues. This means that you can give up to $14,000 to each of your children each year without incurring gift tax. Called “annual exclusion gifts,” these are tax-free and more importantly, do not use any of your lifetime exemption from gift taxes as the gift-giver. This exclusion also applies to anyone you give gifts to—provided that you can afford to give it.
Even after you have reached the annual exclusion for the year, you still need not pay gift taxes for other gifts you make. Federal law grants each person a lifetime gift tax credit which exempts $1 million of gifts from tax. Only after you have given more than $1 million in gifts will you trigger tax issues on the excess.
How does making lifetime gifts affect your exemptions for estate tax? For any taxable lifetime gifts you have made, the difference between the total exemption and the value of the lifetime gifts is your estate tax exemption. Let’s illustrate with an example:
Suppose you died in 2013 and have a gross estate valued at $6,000,000. The total deduction for debts, expenses, and other fees was pegged at $500,000 which puts your net estate value at $5,500,000. Now if you had made $1,000,000 in lifetime gifts, you will have to subtract this from the 2013 allowable estate tax exemption of $5,250,000 to arrive at your available estate tax exemption of $4,250,000. From your net estate of $5,500,000, you subtract $4,250,000 which is your available tax exemption and you will arrive at your taxable estate valued at $1,250,000. You multiply this with the prevailing tax rate of 40 percent to come up with your tax liability of $500,000.
In addition to federal estate tax, you also need to consider the taxes that will be imposed by the state where you live. State tax laws vary from one state to another with some imposing taxes while others don’t so it’s best to talk with your estate planning attorney or tax adviser about what specific rules and guidelines are in place where you live. If you have properties located in other states, you also need to consider how these should be dealt with to minimize your state tax liabilities.
When state taxes are imposed, they can either be in the form of estate taxes which, as you know, are taxes levied on the estate of the deceased minus the expenses and fees or in the form of inheritance taxes which is computed on the value of the asset but is paid by the inheritor or beneficiary of the estate. No matter which type of tax is in place in your state, they have one common effect—that of decreasing the wealth that the heirs are set to receive from the deceased person’s estate.