Policy Basics: The Estate Tax

PDF of this Policy Basics (2pp.)

Updated October 8, 2013

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A long-standing part of the tax system, the estate tax is a tax on property (cash, real estate, stock, or other assets) transferred from deceased persons to their heirs. Fewer than 2 of every 1,000 estates will owe any estate tax in 2013, largely because the first $5.25 million of an individual’s estate ($10.5 million per couple) is exempt.

The tax is levied only on the portion of an estate’s value that exceeds the exemption level, minus deductions, such as for charitable giving.  Taxable estates owe 16.3 percent of their value in tax, on average.  

The estate tax serves as a backstop to the capital gains tax. Usually, capital gains are taxed when the asset is sold or disposed of and the gain is “realized.” But if a person holds an asset that grows in value until his or her death, that “unrealized’ capital gain is forgiven, and neither the heir of the estate nor the deceased person is taxed on it. Without the estate tax, therefore, those unrealized gains would never be subject to taxation.

Estate Tax Has Weakened Considerably Since 2001

Legislation enacted in 2001 gradually phased out the estate tax by raising the exemption level and reducing the rate, leading to the tax’s temporary repeal in 2010. The tax was scheduled to return in 2011 under pre-2001 rules (an individual exemption of $1 million and a top rate of 55 percent), but policymakers have voted twice — most recently in the “fiscal cliff” deal early in 2013 — to continue it in much weaker form. 

Under current law, the exemption level is $5.25 million per person or $10.5 million per couple for 2013, indexed for inflation, and the top rate is 40 percent. Relative to the law in place before the “fiscal cliff” deal, the new estate tax law costs $369 billion over ten years. Compared to the President’s previous budget proposal to set the exemption level permanently at $3.5 million per person ($7 million per couple) and the top rate at 45 percent, the estate tax rules in the fiscal cliff deal cost $118 billion over the next ten years.

Effective Tax Rate Modest Under Current Rules

As noted, taxable estates in 2013 will owe 16.3 percent of their value in tax, on average. This “effective rate” is much less than the top marginal rate of 40 percent for two reasons:

  • The tax is applied only to the value of the estate that exceeds the exemption level. For example, at the current exemption level of $5.25 million per person, an heir of an estate worth $6 million would owe taxes on at most $750,000.
  • The tax contains a number of provisions to reduce heirs’ tax liability, many of them originally designed to protect farmers and small businesses. Most taxable estates have high proportions of liquid assets, so the vast majority of heirs owing estate tax can pay it without selling any property.

Supporters argue that a significant estate tax is critical to supporting public services without imposing onerous burdens on middle-income Americans, particularly given our severe long-term budget problems.

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