Estate Tax: How Inheritance Gets Taxed and Who Pays

A Tax on Wealth at Death

In 2023, only about 4,000 estates in the United States owed federal estate tax — roughly 0.2% of the approximately 2.8 million Americans who died that year. The federal estate tax exemption stood at $12.92 million per individual, meaning that a married couple could pass $25.84 million to heirs before a single dollar of federal estate tax was owed. Despite affecting so few estates, the tax generates outsized political debate, legal complexity, and planning activity among affluent families.

The estate tax applies to the total value of a deceased person's assets — real estate, investments, business interests, life insurance proceeds, and personal property — minus allowable deductions. It is paid by the estate, not by the individual heirs. This distinguishes it from an inheritance tax, where the recipient pays based on what they receive.

Federal Estate Tax Structure

The federal estate tax uses a graduated rate structure. After subtracting the applicable exemption and allowable deductions, the remaining taxable estate faces rates ranging from 18% to 40%. In practice, because the exemption shields the first $12.92 million (as of 2023), only the amount exceeding that threshold is taxed.

The effective rate is always lower than the top marginal rate because the graduated structure applies lower rates to the first dollars above the exemption. An estate worth $15 million in 2023 with the full exemption applied would owe tax on roughly $2.08 million, resulting in an effective tax rate far below 40%.

Estate Tax vs. Inheritance Tax

The terms are often confused. They describe different mechanisms. The federal government levies an estate tax — paid by the estate before assets are distributed. Six states impose an inheritance tax — paid by the heirs based on what they receive. Some states impose both. The distinction matters for planning purposes.

• States with inheritance tax (as of 2024): Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania
• Maryland is the only state that imposes both an estate tax and an inheritance tax
• Inheritance tax rates vary by the heir's relationship to the deceased; spouses are typically exempt
• Children often face lower inheritance tax rates than more distant relatives or unrelated beneficiaries

Key Deductions and Credits

Several deductions reduce the taxable estate. The unlimited marital deduction allows a surviving spouse to inherit the entire estate tax-free, regardless of size. Charitable bequests are fully deductible. Administrative expenses, debts, and funeral costs are also deductible. The portability provision, introduced in 2010, allows a surviving spouse to use any unused portion of the deceased spouse's exemption.

State estate taxes add another layer. Twelve states and the District of Columbia impose their own estate taxes with lower exemption thresholds. Oregon and Massachusetts have the lowest state exemptions at $1 million, meaning estates well below the federal threshold may still owe state estate tax.

The 2026 Sunset Provision

The Tax Cuts and Jobs Act of 2017 roughly doubled the federal estate tax exemption. This increase is scheduled to sunset after December 31, 2025. Without congressional action, the exemption will revert to approximately $7 million per individual (adjusted for inflation) starting in 2026. This looming reduction has driven a surge in estate planning activity as wealthy families attempt to transfer assets before the lower threshold takes effect.

• Lifetime gifts count against the combined estate and gift tax exemption
• The annual gift tax exclusion ($18,000 per recipient in 2024) does not reduce the lifetime exemption
• Gifts to 529 education plans can be front-loaded up to five years of the annual exclusion amount
• Irrevocable trusts established before the sunset preserve the current higher exemption

Planning Strategies Families Use

Estate planning attorneys employ a range of legal tools to minimize estate tax liability. Irrevocable life insurance trusts (ILITs) remove life insurance proceeds from the taxable estate. Grantor retained annuity trusts (GRATs) allow asset appreciation to pass to heirs tax-free. Family limited partnerships can transfer business interests at discounted valuations. Qualified personal residence trusts (QPRTs) remove a home from the estate while allowing the owner to continue living in it for a specified term.

Historical Context and Ongoing Debate

The federal estate tax was first enacted in 1916, with a top rate of 10% and an exemption of $50,000. Rates peaked at 77% in 1941. Since then, the exemption has steadily risen while rates have fallen. The tax collected approximately $18.4 billion in fiscal year 2022, a small fraction of total federal revenue but a significant sum concentrated among a few thousand families.

Proponents argue the estate tax reduces wealth concentration across generations and raises revenue from those most able to pay. Opponents contend it amounts to double taxation of assets already subject to income tax and can force the liquidation of family farms and businesses. Empirical evidence on farm and business liquidation is limited, with IRS data showing that fewer than 80 small farm or business estates owed any federal estate tax in 2020.

This article is for informational purposes only and does not constitute financial advice.