What Is Estate Tax and Who Pays It?

Federal estate tax is a transfer tax levied on the transfer of assets at death if the estate exceeds the federal exemption threshold. At a 40% federal rate (the highest in the U.S. tax code), estate tax can eliminate 40 cents of every dollar above the exemption limit. Yet fewer than 0.1% of estates actually owe federal estate tax, because the exemption is extraordinarily high: $13.61 million per person (as of the mid-2020s). For most investors, estate tax is irrelevant. However, for the affluent and ultra-high-net-worth—those with $20 million, $50 million, or $100 million in assets—estate tax is often the single largest tax burden they will face, potentially exceeding $5 million to $20 million or more. Understanding what triggers estate tax, how it is calculated, and which planning strategies (portability, trusts, gifting, GRATs) can reduce it is essential for wealth preservation and efficient intergenerational transfer.

Quick definition: Federal estate tax is a 40% tax on the transfer of assets exceeding $13.61 million per person at death. It applies to U.S. citizens with taxable estates above this threshold. State estate and inheritance taxes add additional burden in 17 states.

Key takeaways

• Federal estate tax applies only to estates exceeding $13.61 million per person ($27.22 million per married couple with portability).
• The federal estate tax rate is a flat 40%, the highest marginal rate in the U.S. tax code.
• The exemption is set to sunset to approximately $7.4 million per person in 2026 unless Congress extends it.
• State estate and inheritance taxes add 12–20% in 17 states, potentially bringing combined rate to 50%+.
• Portability, trusts, GRATs, and charitable giving can reduce or eliminate estate tax exposure.

What Is the Taxable Estate?

The taxable estate is the gross value of your assets at death, minus specific deductions, less the federal exemption.

Gross estate includes:

• Real estate (primary residence, investment property, vacation homes)
• Financial accounts (stocks, bonds, mutual funds, bank accounts)
• Retirement accounts (401k, IRA, Roth—all included in gross estate for non-spouse beneficiaries)
• Life insurance policies (if you own them)
• Business interests (company stock, partnership interests)
• Art, collectibles, vehicles
• Intellectual property, patents, royalties

Deductions and adjustments:

• Mortgages and debts (subtracted from gross estate)
• Charitable deductions (if you gift to qualified charities in your will or via trust)
• Marital deduction (unlimited transfer to spouse)

The federal exemption: $13.61 million per person (2024–2025). Any estate value above this threshold is subject to 40% federal tax.

Calculation: Taxable Estate = Gross Estate - Deductions - Exemption Federal Estate Tax = Taxable Estate × 40%

Example: Marcus has a $30 million estate. His debts total $1 million. His exemption is $13.61 million. His taxable estate is $30 million - $1 million - $13.61 million = $15.39 million. His federal estate tax is $15.39 million × 40% = $6.156 million. His heirs receive $30 million - $6.156 million = $23.844 million.

Who Pays Estate Tax?

Estate tax is a federal obligation of the estate, not individual heirs. However, the estate's executor must file Form 706 (Federal Estate Tax Return) and pay the tax before distributing assets to heirs. The heirs effectively bear the burden because the tax is paid out of estate assets before they inherit.

In the example above, Marcus's executor pays $6.156 million in federal estate tax. The remaining $23.844 million is distributed to heirs. If the estate does not have enough cash to pay the tax, the executor may need to sell assets (stocks, real estate) to raise funds. This forced liquidation can be costly.

The Exemption Sunset Issue

The federal estate tax exemption is scheduled to sunset on January 1, 2026. Under current law, the exemption will drop from $13.61 million per person to approximately $7.4 million per person (adjusted for inflation). This is a seismic shift in planning.

A married couple with a $25 million estate is currently safe: their combined exemption is $27.22 million, far exceeding their estate. However, if the exemption sunsets to $7.4 million, their combined exemption drops to $14.8 million. A $25 million estate now has $10.2 million in taxable exposure, triggering approximately $4.08 million in federal estate tax.

The timeline is critical. If the account owner dies before January 1, 2026, the $13.61 million exemption applies. If they die after December 31, 2025, the lower exemption applies (unless Congress extends the higher amount).

To address this risk, some high-net-worth investors are using their exemption now—making large gifts or funding irrevocable trusts during their lifetime—to lock in the $13.61 million exemption before it sunsets. This is called a preponing strategy.

Life Insurance and Estate Tax Liquidity

For large estates, federal estate tax creates a liquidity crisis. The estate may own assets (business, real estate) that cannot be easily liquidated. Yet the tax must be paid within nine months of death (with a possible extension).

Many high-net-worth individuals use irrevocable life insurance trusts (ILITs) to solve this problem. The ILIT owns a life insurance policy; at death, the proceeds (typically $5 million to $50 million+) pass outside the taxable estate and provide liquid funds to pay estate tax.

Example: A business owner with a $50 million estate (including a $40 million business not easily saleable) faces approximately $14.56 million in federal estate tax. The business cannot be sold immediately, so there is no cash to pay the tax. The executor might be forced to sell part of the business at a discount or take a loan. An ILIT owning a $15 million insurance policy solves this: at the owner's death, the $15 million passes to the ILIT (outside the taxable estate), providing ample liquidity to pay taxes and cover transition costs.

State Estate and Inheritance Tax Coordination

Federal estate tax is only one layer. Seventeen states plus Washington D.C. impose their own estate and inheritance taxes on top of the federal 40%. For a resident of Massachusetts, the combined federal-state rate can reach 56% (40% federal + 16% Massachusetts).

For multi-state planning, consider:

• Domicile: Where you establish legal residency affects which state taxes apply. Moving to a no-estate-tax state (Texas, Florida, Tennessee) can save millions.
• Portability: Federal portability (discussed earlier) does not extend to state taxes. State planning requires separate trust structures.
• Situs of property: Real estate and business interests are generally taxed in the state where they are located, regardless of your domicile.

A $50 million estate for a Massachusetts resident faces federal tax of approximately $14.56 million plus Massachusetts state tax of approximately $4 million—total: $18.56 million. The same $50 million estate for a Texas resident faces only the $14.56 million federal tax. The domicile difference: $4 million.

Core Planning Strategies

Portability Between Spouses

Allows the surviving spouse to claim the deceased spouse's unused federal exemption. For a married couple, this effectively doubles the exemption to $27.22 million. Requires filing Form 706 and electing portability, even if no estate tax is owed.

Advantage: Simple; no trusts required. Disadvantage: Relies on surviving spouse's honesty/discipline in not overspending and doesn't address state estate taxes.

Irrevocable Trusts and Irrevocable Life Insurance Trusts

Remove assets permanently from your taxable estate. An ILIT holding life insurance removes insurance proceeds (a major estate asset for some families) from the estate.

Advantage: Substantial tax savings for large estates. Disadvantage: Loss of control; irrevocable commitments.

Gifting and Lifetime Exemption Use

Use your $13.61 million exemption to make gifts during your lifetime rather than at death. Removes both the gifted assets and all future appreciation from your taxable estate.

Advantage: Removes future growth. Disadvantage: Triggers gift tax return filing; may not be necessary if estate is below exemption.

GRATs and Other Specialized Trusts

Allow transfer of appreciated assets with minimal gift tax by retaining an annuity payment while allowing excess growth to pass tax-free.

Advantage: Efficient transfer of highly appreciated assets. Disadvantage: Complex; requires IRS discount rate cooperation.

Charitable Giving and Donor-Advised Funds (DAFs)

Transfer appreciated assets to charity or a DAF. Receive a deduction equal to the asset's fair market value, reducing the taxable estate by the full amount.

Advantage: Tax deduction + asset removal from estate. Disadvantage: Assets committed to charitable purposes.

Disclaimer Strategy

Heirs can disclaim (refuse) inherited assets, allowing them to pass to alternate beneficiaries. Can be used to bypass highly-taxed estates and distribute to lower-tax-bracket family members.

Advantage: Flexibility after death when actual circumstances are known. Disadvantage: Must happen within 9 months; irrevocable once disclaimed.

A Decision Framework for Estate Tax Exposure

Real-World Examples

Example 1: The Mid-Sized Estate and Exemption Sunset A 60-year-old software executive has $20 million in assets. The current federal exemption is $13.61 million; she has $6.39 million in exposure. If she dies today, her estate owes approximately $2.56 million in federal tax. However, she is in good health and expects to live 20 years. During those 20 years, her assets grow at 6% annually, reaching approximately $65 million at age 80. If the exemption sunsets to $7.4 million in 2026 and remains there, her $65 million estate faces federal tax on $57.6 million, generating approximately $23.04 million in federal tax.

To address this, the executive should consider: (1) gifting $6 million now to family members or a trust, using her exemption while it's high; (2) funding a GRAT with $10 million of her highest-growth assets; (3) establishing an ILIT with life insurance for liquidity. These strategies could reduce her ultimate estate tax by $5 million to $10 million.

Example 2: The Family Business and Estate Tax A business owner has a company worth $40 million (her only major asset). Her personal residence and financial accounts total $5 million. Total estate: $45 million. Federal exemption: $13.61 million. Taxable estate: $31.39 million. Federal tax: approximately $12.56 million.

The problem: $40 million of the estate is illiquid (the business). To pay $12.56 million in taxes, the executor must sell part of the business or borrow against it—both expensive and disruptive. The owner should:

1. Fund an ILIT with a $15 million insurance policy. The proceeds provide liquidity to pay taxes without selling the business.
2. Implement a succession plan allowing a co-owner or key employee to buy the business at a discounted price if insurance proceeds are available.
3. Consider a grantor retained annuity trust (GRAT) funded with minority interests in the business, removing future growth from the estate.

Example 3: The Couple and Portability Robert and Susan have a $28 million estate ($14 million each). The federal exemption is $13.61 million per person; their combined exemption is $27.22 million. They have only $780,000 of taxable exposure between them—essentially no federal estate tax concern if they use portability.

However, they live in Massachusetts, which has a $1 million exemption per person. Their state estate tax exposure is ($14 million - $1 million) × 16% = $2.08 million for each spouse, totaling approximately $4.16 million in state tax.

The solution: (1) Move to Florida (no state estate tax) and establish Florida domicile; (2) If moving is not feasible, use Massachusetts bypass trusts to address state estate tax specifically; (3) Coordinate federal portability with state planning.

Example 4: The Philanthropist and Charitable Planning A widow with $50 million in assets is deeply committed to charitable giving. She plans to give $10 million to charity during her lifetime or at death. Rather than simply leaving $10 million to charity in her will, she should:

1. Transfer $10 million in appreciated stock to a charitable remainder trust (CRT) during her lifetime. She avoids capital gains tax on the stock ($3 million–$5 million in gains), receives an income deduction, receives income for life, and the remainder passes to charity.
2. Use the tax savings from the deduction and avoided gains to fund a wealth replacement ILIT that leaves additional assets to her family.

Net result: Charity receives their $10 million; she gives the same $10 million to charity; but she retains more wealth in her family (through the ILIT funded with tax savings) than if she'd simply given $10 million outright.

Common Mistakes

Mistake 1: Assuming you don't owe estate tax because your estate "feels small" Many people grossly underestimate their estate value. The family home ($2 million–$5 million), retirement accounts ($500,000–$2 million), life insurance ($1 million–$10 million), and investment accounts ($2 million–$10 million) add up quickly. Your estate is larger than you think.

Mistake 2: Ignoring the exemption sunset The exemption is scheduled to drop from $13.61 million to $7.4 million in 2026. If you have an estate above $7.4 million, you should begin planning now. Waiting until 2026 to act may be too late.

Mistake 3: Failing to elect portability Many estates skip filing Form 706 because no estate tax is owed. However, portability must be elected on Form 706. Without the election, the deceased spouse's unused exemption is permanently lost. File Form 706 to preserve portability, even if no tax is due.

Mistake 4: Holding life insurance in your own name If you own the life insurance policy, the death benefit is included in your taxable estate. An ILIT is a simple fix that removes the death benefit from your estate, saving 40% federal tax on the proceeds.

Mistake 5: Not coordinating state and federal planning Federal exemption is high ($13.61 million), but state exemptions are low ($1 million–$5.85 million). Families in state estate tax states need separate planning (bypass trusts, domicile shifts) to address state exposure, not just federal.

FAQ

How much does it cost to file Form 706?

If your estate owes no federal tax but you're filing to elect portability, the cost is typically $2,000–$5,000 for an accountant or tax attorney to prepare the return. For larger estates owing tax, the cost can be $5,000–$25,000+. These costs are paid by the estate.

If my spouse dies, will I automatically get to use their unused exemption?

No. You must file Form 706 and affirmatively elect portability. Without the election, the unused exemption is lost forever. File the return even if no tax is owed.

What happens if I die before using my entire exemption?

Your unused exemption is generally lost (or can be used by your surviving spouse if you elect portability). Exemption does not carry forward; it is lost upon death. If you have exemption room, consider using it during your lifetime.

Can I plan to have my estate be just under the exemption to avoid estate tax?

Yes, in theory. However, your estate is hard to predict and control precisely. Assets appreciate unexpectedly, you may receive inheritances, business valuations change. Assuming your estate will stay "just under" the exemption is risky. Better to use trusts or gifting strategies to deliberately reduce your estate below the threshold.

Does the 40% federal estate tax rate ever change?

Yes. Congress can change the rate and exemption amount. Historically, the rate has ranged from 18% to 77% depending on the era. The exemption has also swung widely. Monitor legislative changes.

Can I reduce my estate tax by giving assets to my children before death?

Yes. Lifetime gifts reduce your exemption, but they also remove the gifted assets and all future appreciation from your taxable estate. For large estates with expected appreciation, lifetime gifting can be highly effective.

If I leave everything to my spouse, do I owe estate tax?

No. The unlimited marital deduction allows unlimited transfer of assets between spouses with no federal estate tax. However, the assets will be in your spouse's estate at their death, potentially triggering tax then. Portability can address this.

Does state estate tax apply to life insurance proceeds?

Yes, in state estate tax states. If you own the insurance policy and the death benefit is included in your taxable estate, the state taxes it along with other assets. An ILIT removes it from your estate for both federal and state tax purposes.

Related concepts

• Estate Tax Portability Between Spouses
• State Estate and Inheritance Taxes
• Gifting Appreciated Assets
• Trusts and Estate Tax
• Inherited Retirement Accounts and Taxes

Summary

Federal estate tax is a 40% transfer tax that applies only to estates exceeding $13.61 million per person (as of the mid-2020s). While few investors owe federal estate tax due to the high exemption, it remains the single largest tax burden for ultra-high-net-worth individuals. The exemption is scheduled to sunset to $7.4 million per person in 2026, creating a significant planning window for those with estates above this threshold. Strategic planning—including portability between spouses, irrevocable trusts, life insurance trusts, GRATs, and charitable giving—can reduce estate tax from hundreds of thousands to tens of millions of dollars. State estate and inheritance taxes add an additional layer of burden in 17 states, requiring separate planning. Understanding your estate size, monitoring legislative changes, and consulting an estate planning attorney is essential for preserving wealth across generations.

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