Living isn't cheap, but neither is dying in America -- particularly if you leave behind a substantial estate and live in a state that imposes an inheritance tax, estate tax or both. Understanding how death taxes work and how you can legally minimize the taxes on your estate can help you leave more money to those you love and less to the government.
Estate Versus Inheritance Taxes
Technically, America doesn't have an inheritance tax, at least on the federal level. The federal government does have an estate tax, however. The distinction is small, but significant. With an inheritance tax, the heirs each pay taxes on what they receive. With an estate tax, the tax is imposed on the decedent's estate as a whole before the money is paid out to each beneficiary. For example, if you receive money from your grandparent's estate, you wouldn't owe any estate taxes on that money, but you might owe inheritance taxes.
Estate Tax Rates
For people dying in 2013, the federal government imposes a tax of 40 percent on the amount of the estate that exceeds the exemption limit -- $5,120,000 as of the 2012 tax year and indexed for inflation. For example, say your estate is $3 million over the exemption -- a nice problem for most Americans to think about. You would owe a $1.2 million federal estate tax. However, any gift tax exemptions you've used during your lifetime chip away at this $5.12 million -- it's called the "unified credit" for this reason, because it includes gifts as well as your estate. This means that if you've made sizable gifts during your life, the exemption for your estate might be smaller.
Estate Tax Exclusions
You get to reduce the total estate by taking advantage of a number of deductions and exclusions that aren't taxable. For example, you can transfer as much as you want to your spouse through your estate without paying any taxes. Similarly, any money you leave to charity is deducted from your estate. In addition, any debts you owe offset the value of the estate. For example, say you die owning a $500,000 home that's secured by a $300,000 mortgage -- only $200,000 would be added to your estate.
State Inheritance Taxes
According to the SmartMoney website, six states have just inheritance taxes -- Indiana, Iowa, Kentucky, Nebraska, Tennessee and Pennsylvania -- with rates ranging from 9.5 percent to 20 percent. Another 14 states and Washington, D.C., have only an estate tax (on top of the federal estate tax). But, if you live in New Jersey or Maryland, you get both a state estate tax and a state inheritance tax -- on top the federal estate tax. The Maryland inheritance tax rate is 10 percent, and the rate in New Jersey is 16 percent. So, depending on where you live and die, your heirs could watch half your estate or more get eaten up by taxes.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."