How Does Estate Tax Work?

Did you know you can sell all or a portion of a life insurance policy, even term insurance?

(4 minute read)

The words “estate tax” get lots of people worried about the future of their legacy. But in truth, the majority of estates are too small for the holders or beneficiaries to be concerned with estate taxes or inheritance taxes. We’re sharing the basics of estate tax in 2021, as well as what changes might be ahead for these policies under the new Biden Administration.

Basics of Federal Estate Tax in 2021

At the end of 2020, only estates worth $11.58 million or more are subject to any federal estate tax. For individuals passing away in 2021, this threshold is fixed at $11.7 million. The value of the estate is based on today’s fair market value. For instance, if you bought a house worth $7 million that assesses for $5 million today, it will be counted as having a $5 million value.

Any assets from the estate that are left to a surviving spouse are not counted toward the value of the estate to determine if it will be taxed. That means a spouse could inherit billions without paying taxes. However, when the spouse passes away, what remains of the estate left to the heirs will be taxed.

The amount of estate tax paid depends on the amount by which the value of estate exceeds the threshold. If you have just $10,000 more than $11.58 million, those additional dollars will be taxed at 18%. If you have a million dollars or more beyond the threshold, this extra money will be taxed at the maximum possible rate of 40%. In between, there are brackets of increasing taxation as the additional dollars add up.

Keep in mind, all this is in reference to the amounts above and beyond the threshold. Estates worth less than $11.58 million (or $11.7 million if the owner passes away in 2021) are not subject to federal tax. 

How Biden Might Change Federal Estate Tax 

President Biden has floated the idea of some changes to how generational wealth is taxed as it is passed down through an estate. To understand these changes, we have to understand how step up in basis works.

Let’s return to the example of a home purchased for $7 million, but assume it increased in value and is worth $9 million today. The heirs of the estate sell the home for $10 million. Because the value of the home was automatically “stepped up” as part of the estate valuation, the sellers only pay taxes on the $1 million of their profits that are outside the valuation in the estate. Some critics of this loophole argue that the heirs are then making an additional $2 million that will never be taxed—because it will not be taxed in the estate and is not taxed as capital gains.

President Biden proposes to eliminate this loophole by taxing the step up in basis valuation when the estate is assessed. This means the heirs of the estate pay taxes on the increased value whether they sell the asset or not. Of course, Congressional approval would be needed to codify these changes into law—so keep your eyes on the news. 

Which States Have Estate and Inheritance Taxes?

In addition to federal estate tax, there are 12 states and the District of Columbia that have estate tax. The smallest estate subject to tax in any jurisdiction is $1 million, though the threshold varies.  As with federal tax, these jurisdictions tax the amount above the threshold on a sliding basis.

Additionally, there are six states that tax inheritance if the heir isn’t closely related to the individual who has passed. Spouses are not taxed on inheritance in any state. Descendants are only taxed in Nebraska and Pennsylvania. Domestic partners and divorced spouses may also not be taxed depending on the laws of the state. If you live in a state with an inheritance tax, like with estate tax, there is a threshold dollar amount that will trigger whether or not you pay taxes.

Ultimately, estate tax and inheritance tax laws establish limits on the amount that can be passed tax-free down to children and other loved ones. For high-net-worth individuals, navigating the estate tax is a means to pass the most possible wealth down to the next generations. Sometimes that means creative investment in assets like real estate, life insurance, and more, as well as donations to charities or establishing trusts to minimize tax liability. If you think the value of your estate might approach the estate tax threshold, we recommend working with an estate planning professional to ensure your legacy meets your wishes.

Did you know you can sell all or a portion of a life insurance policy, even term insurance? Selling an unwanted life insurance policy is no different than selling your car, home or any other valuable asset that will create immediate cash. Contact us today to learn more.

Leo LaGrotte
Life Settlement Advisors
llagrotte@lsa-llc.com
1-888-849-0887

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