Most people don’t pay estate taxes when they die -- one has to be worth $5 million before federal taxes kick in. But I was working on a will, tax laws can change, and I wanted to learn more about how death taxes operate. Here’s what I found. Details may be incomplete but the information is generally correct.
The federal government imposes an
estate tax on the right people have to transfer wealth after they die. The tax is levied on the executor of the deceased’s estate, who files a tax return and pays it from estate funds. If there’s not enough money, property is sold to raise cash for the tax (heirs are not responsible for taxes unless the executor fails to pay them). Estate taxes reduce the pool of assets that are passed on to inheritors. Some states charge an estate tax too by piggy-backing onto federal estate tax returns.
In addition to this, some states impose a separate
inheritance tax on the right a person has to receive wealth from deceased person. A single state tax return is prepared and each beneficiary is individually responsible for paying the tax. Normally an executor will pay state inheritance taxes on behalf of beneficiaries, deducting the amounts from each person’s gift, before distributing assets to them. If there is no executor, beneficiaries must deal with the tax themselves. The federal government does not impose inheritance taxes.
Who Bears Death Taxes
By statute, people give up a share of the assets they inherit to pay death taxes. Someone inheriting 30% of an estate bears 30% of the taxes. These are not income taxes; people don’t report them on their income tax returns. Rather a person’s inheritance is reduced by this amount before property is distributed to them. Some inheritors are automatically exempted -- death taxes are not assigned to spouses nor to charities, for example. Having each beneficiary bear their fair share of taxes sounds equitable, but it can cause some problems. If someone inherits property like a car or jewelry, they may have to give some of their own money back to the estate so the executor can properly remit taxes attributable to those assets.
To avoid this situation, many people write their wills with a tax exoneration clause, or apportionment clause, that waives the statutory apportionment of death taxes. They want taxes paid up-front directly from the estate so inheritors receive gifts that are not reduced by taxes. This is a nice gesture, but it can cause problems too. Here a few definitions are needed.
A
specific beneficiary inherits something specific from a will, for example a $10,000 gift or a stamp collection. A
residuary beneficiary receives everything left from an estate after specific gifts and expenses and taxes have been satisfied (the residual). A
residuary estate is the amount of a person’s estate that remains after the deductions above have been made. A
taxable estate is everything a deceased person owned that is subject to death taxes, including wealth that passes to people outside the provisions of a will. A
testamentary estate includes only those assets that are distributed through a will. Properties distributed through a will after a person’s death are testamentary assets or
probate assets. Properties distributed to people outside of a will after someone dies are non-testamentary assets or
non-probate assets. Non-probate assets include wealth that passes to
designated beneficiaries named in life insurance policies, retirement accounts like IRAs and 401K plans, bank accounts with POD payable on death provisions, brokerage accounts with TOD transfer on death provisions, and assets like cars and homes that have a survivorship interest specified in their titles.
If apportionment is waived, taxes are normally paid from the residuary estate, which becomes that much smaller. This means residuary beneficiaries bear the entire tax burden -- specific beneficiaries are off the hook entirely. And so are designated beneficiaries that receive non-probate assets -- since many people have a majority of their wealth invested in IRAs and other retirement accounts, these assets can be substantial. People may not want estate taxes payable, say, on a bank account that passes to a designated beneficiary to be paid out of property that passes to residuary beneficiaries. So that can be a problem.
One Approach to Consider
One idea is to not put a standard boilerplate clause in a will waiving apportionment and to not add complicated language about who bears what. Rather, exonerate taxes specifically on those particular gifts where it makes sense. If you want to leave an expensive heirloom to your grandchild tax-free, just say it is your intention to exonerate that bequest from contributing to the payment of any death, inheritance or estate taxes. Then let statutory apportionment work as designed so all other inheritors pay taxes in proportion to what they receive, including an extra little portion to cover taxes on exonerated gifts.
