Quick summary
Estate tax is a tax on the transfer of a deceased person’s assets when the total estate value exceeds the applicable exemption. Federal law sets a high exemption threshold (adjusted annually for inflation) and graduated tax rates for taxable estates. Many planning tools — trusts, lifetime gifts, charitable strategies, and portability elections — help reduce or eliminate the federal estate tax liability. State estate or inheritance taxes can apply even when there is no federal tax.
Background and recent context
The federal estate tax has existed in various forms since the early 20th century and is frequently adjusted through legislation and inflation indexing. Because the federal exemption is indexed each year, the dollar threshold that triggers estate tax changes; many high-net-worth families track the annual IRS figures when planning transfers. For official federal guidance, see the IRS Estate and Gift Taxes page (irs.gov) and the IRS Estates topic page (irs.gov/businesses/estates).
Note: many of my clients worry the estate tax will apply to modest estates. In practice, only a small percentage of U.S. estates meet the federal liability threshold in any year — but state-level estate or inheritance taxes can affect additional households.
How the estate tax works (step-by-step)
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Valuation of the gross estate: At death, the executor gathers and values the decedent’s worldwide assets (U.S. situs rules vary for nonresident decedents). Typical assets include real estate, brokerage accounts, retirement accounts, business interests, life insurance proceeds owned by the decedent, and personal property. Appraisals are often required for real estate and collectibles.
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Allowable deductions: The gross estate is reduced by valid deductions such as outstanding debts, funeral expenses, certain administration costs, mortgages, and transfers to a surviving spouse (unlimited marital deduction) or qualifying charities.
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Adjusted taxable estate: After applying deductions and allowable credits, you reach the taxable estate. If the taxable estate exceeds the federal exemption, estate tax is calculated on the excess using the graduated rates set by law.
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Credits and special elections: Executors can claim credits (including the unified credit that corresponds to the exemption) and make elections like portability of the deceased spouse’s unused exemption (DSUE) — see “What is Portability of the Estate Tax Exemption?” for details.
For current procedural and filing rules, including Form 706 (U.S. Estate Tax Return), consult IRS resources (irs.gov/forms-pubs/about-form-706).
Examples (realistic scenarios)
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Example A (high-level illustration): A decedent’s gross estate is $15 million and deductions reduce the taxable estate to $14 million. If the applicable federal exemption for the year were $12.92 million (a recent historical figure), the taxable amount would be $1.08 million and estate tax would be computed on that amount using the federal estate tax schedule.
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Example B (planning outcome): A business owner uses an irrevocable trust and lifetime gifting strategies to remove $2 million of business interests from his estate before death. At death the taxable estate falls below the exemption threshold, eliminating federal estate tax liability.
These examples are illustrative. Exact tax owed depends on current exemption levels, tax rates, deductions, state rules, and whether portability or other elections apply.
Who is affected and when to plan
- Primary impact: High-net-worth individuals whose estates (after deductions) approach or exceed the federal exemption in force at death.
- Secondary impact: People in states with their own estate or inheritance taxes (for example, New York, Massachusetts, Oregon, and several others have state-level rules and lower exemptions). State rules differ widely — review your state’s tax agency guidance.
Timing: Start planning early. Business succession, transfers of closely held entities, and real estate appreciation create exposure that may take years to address. In my practice I usually begin estate-tax-focused planning when a client’s net worth begins to approach 60–75% of the then-current federal exemption, because some strategies (trusts, Gifting, family limited partnerships) require lead time.
Common planning strategies (what works and when)
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Trusts: Irrevocable life insurance trusts (ILITs), intentionally defective grantor trusts (IDGTs), and qualified personal residence trusts (QPRTs) can remove appreciating assets from the taxable estate when structured correctly. See our related article on Understanding Trusts and Estate Tax Filing Requirements.
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Lifetime gifting: Use the annual gift tax exclusion (annual exclusion amount is indexed and applies per donee) and the lifetime unified credit to move wealth out of your estate. Large gifts can be made using valuation discounts for fractional interests in family partnerships, but these techniques attract IRS scrutiny and need careful documentation.
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Portability: Surviving spouses can elect to use a deceased spouse’s unused exclusion (DSUE) — a portability election — by filing Form 706 within nine months of death (with an automatic six‑month extension available). For more, read What is Portability of the Estate Tax Exemption?.
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Charitable strategies: Charitable remainder trusts (CRTs), charitable lead trusts (CLTs), and direct bequests can reduce taxable estate value while supporting philanthropic goals and providing income or tax benefits.
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Business succession tools: Family limited partnerships (FLPs) and grantor retained annuity trusts (GRATs) are frequently used to transfer business interests while taking advantage of valuation discounts and fixed-term transfers. These strategies require professional valuation and strict adherence to formalities.
Each strategy has trade-offs — loss of control, gift-tax consequences, generation-skipping transfer tax (GST) considerations, and potential state tax impacts. Work with an estate planning attorney and CPA to design a tailored plan.
Practical tips I use with clients
- Revisit beneficiary designations on retirement accounts and life insurance — these override wills for beneficiary transfers and can create large taxable events. Nonspouse beneficiaries may face income tax consequences when inheriting retirement accounts.
- Coordinate marital planning: If married, consider portability, spousal trusts, or splitting assets to use both spouses’ exemptions efficiently.
- Use annual review checkpoints: Revalue closely held business interests and real estate every 3–5 years, more often when markets move sharply.
- Document transactions: Gifting and family partnership transfers must be properly documented to withstand IRS review.
Common mistakes and misconceptions
- Mistake: “Estate tax hits all estates.” Reality: Only estates above the federal exemption (and certain state thresholds) owe federal estate tax.
- Mistake: “Retirement accounts aren’t part of the estate.” They can be — the income tax treatment for heirs differs, and IRA/401(k) balances may increase estate tax exposure if owner retains incidents of ownership or fails to name beneficiaries correctly.
- Mistake: “A will alone solves estate tax exposure.” A will controls distribution but doesn’t remove assets from the taxable estate; irrevocable trust planning and gifting are often needed to reduce tax exposure.
Filing, timing, and compliance notes
- Federal Form 706 must generally be filed within nine months of death. An extension to file is available, but extension of time to pay is limited. Executors should consult a tax advisor early to estimate potential estate tax and plan for liquidity (life insurance, sale of assets, or installment payments under Section 6166 for certain closely held businesses).
- When a portability election is desired, Form 706 must be filed even if no estate tax is due, to preserve the deceased spouse’s unused exemption for the surviving spouse. See IRS guidance on portability.
State estate and inheritance taxes
Even if the federal estate tax is not triggered, several states impose their own estate or inheritance taxes with different exemption levels and tax rates. Confirm your state rules — a strategy that avoids federal tax may still leave state exposure.
Frequently asked questions
Q: How do gift taxes interact with estate taxes?
A: Lifetime gifts above the annual exclusion reduce your lifetime unified exclusion and therefore can lower the remaining estate tax exemption available at death. Gifts that used part of your lifetime exemption won’t be double taxed, but they reduce the credit (or exemption) available at death.
Q: Can I avoid estate tax entirely?
A: Many estates avoid federal estate tax by staying under the exemption or using tax‑efficient planning. For very large estates, planning can significantly reduce but not always completely eliminate estate tax exposure.
Q: What if a state has an inheritance tax?
A: Inheritance taxes are paid by beneficiaries based on what they receive, and exemptions and rates vary by state. Executors must research state filing rules and deadlines.
Professional disclaimer
This article is educational and not individualized tax, legal, or financial advice. Estate tax laws change and thresholds are adjusted annually. Consult a qualified estate planning attorney and a tax professional before implementing specific strategies.
Authoritative sources and further reading
- IRS — Estate and Gift Taxes: https://www.irs.gov/businesses/small-businesses-self-employed/estate-and-gift-taxes
- IRS — Estates topic & Form 706 information: https://www.irs.gov/businesses/estates
- Consumer Financial Protection Bureau — estate planning basics and resources
Further internal resources on FinHelp:
- What is Portability of the Estate Tax Exemption? — https://finhelp.io/glossary/what-is-portability-of-the-estate-tax-exemption/
- Understanding Trusts and Estate Tax Filing Requirements — https://finhelp.io/glossary/understanding-trusts-and-estate-tax-filing-requirements/
- Estate Tax Planning — https://finhelp.io/glossary/estate-tax-planning/
If you want a customized review of potential estate tax exposure, consult a certified estate planning attorney or CPA. In my practice, early coordination between legal and tax advisors produces the best outcomes for families facing complex ownership and succession issues.
