How Does Inheritance Tax Work?

Understanding how the inheritance tax works can help you protect your heirs and rest in peace.
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Death tax. Inheritance tax. Estate tax. Whatever you want to call it, dying can be expensive for your heirs. It is said that the only things you can count on are death and taxes, and the estate tax combines both dreaded events. Understanding the tax will help you prepare an estate plan that minimizes its impact on your heirs.

What's Included in Your Estate

Pretty much everything you own is included in your estate: your house, 401(k), the crystal punch bowl you bought at a flea market and the shirt off your back. The value of all of those items added together adds up to the net value of the estate. It doesn't matter what you originally paid for the items. Valuations are based on current fair market value.

Recent Tax History

The estate tax was gradually phased out by legislation enacted in 2001 but set to return to pre-2001 levels in 2011. The 2011 tax was set with a $1 million per-person exemption and a top rate of 55 percent. Estate tax legislation is vulnerable to the whims of Congress and can change from year to year.

The Benefits of Marriage

One of marriage's best financial benefits comes on your death bed. Spouses inherit the other spouse's unlimited assets free and clear. Now here comes the rub. If you die and leave your entire estate to your spouse, your heirs cannot benefit from your individual estate tax exemption. Say your combined net worth as a couple is $2 million. If you die and leave half, or $1 million, to your children, they inherit it tax free. When your spouse later dies and leaves the children the remaining $1 million, that is tax free as well. If, on the other hand, you leave the whole amount to your spouse, when that person dies the children will have to pay estate taxes on the second million. That's because as an individual the surviving spouse still only has a $1 million exemption. Careful estate planning can avoid this pitfall.

Estate Tax Procedures

Upon death the executor of the estate must file a tax return within nine months of the date of death if the gross estate exceeds the exemption amount. Funeral expenses, legal and administrative fees and estate taxes paid to the state may be deducted. The portion of the estate up to the exemption amount is not subject to an inheritance tax, but any amount above that will require payment on a sliding scale based on the total value of the estate. It doesn't matter how many beneficiaries there are. What matters is the total value of the estate, whether it passes to one beneficiary or to 100. Many states also have separate estate taxes, so you'll need to research what specific policies and procedures because they vary greatly for each state.

Special Exemptions

Family-owned farms and closely-held businesses are eligible for a reduced estate tax or may be able to spread payments out over a period of time. There are special formulas to calculate if or when a tax is due. An estate planning or tax attorney should be consulted in these cases or for other related matters. The estate tax allows unlimited deductions for donations to charity, so it is possible to eliminate estate taxes by donating any amount over the exemption amount to a charity of your choice.

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