What you don't know about the estate tax

As one of the most politically charged subjects in the world of estate planning, the estate tax as a topic of conversation tends to produce more light than heat. That atmosphere could be part of the reason why many clients — and even some advisors — overreact to the potential of its effects, or at least are unaware of its actual impact.

The debate over the estate tax — or the death tax, if you prefer — tends to involve a great deal of rhetoric and ideology and not a lot of facts and figures. If your clients are wondering about the specific effect the estate tax is likely to have on them, here is some important background:

• The estate tax exemption, as everyone knows, is currently pegged at $5.25 million. The figure is intended to be relatively static. It’s indexed for inflation set at a more or less permanent level of $5 million in 2011 dollars.

  So obviously, the estate tax reaches only a few families. According to the Tax Policy Center (TPC), a Washington think tank, a total of 3,780 estates will owe any tax at all. That means 0.14 percent of all people who die in 2013 will be affected by the estate tax.

• The current estate tax rate is 40 percent. But, remember, that comes after the first $5.25 million in an estate has already been exempted. The effective tax rate on an estate subject to the tax, as calculated by TPC, is actually 16.6 percent for 2013.

  Since the first $5.25 million is exempt, the effective tax rate increases as the amount of the estate increases. Or, to look at it another way, the smaller the estate, the smaller the effective tax rate. Estates with more than $20 million in assets end up paying an effective tax rate of 18.8 percent, according to TPC. Estates with $10 million to $20 million pay an average of 15.8 percent. The smallest estates subject to the tax, those with $5 million to $10 million, pay an average effective rate of 7.7 percent.

See also: How the permanent estate tax will impact life insurance ownership

• A sizable portion of the estates that end up being taxed consists of unrealized capital gains. A little more than a third of the value of those estates is in those capital gains, according to a study by two economists in a paper published the National Bureau of Economic Research. That research dates back to 2000, so it may be a bit outdated by now. Interestingly enough, the paper also notes that if the unrealized capital gains in estates were simply taxed as capital gains but the estate tax were abolished, most people with smaller estates would end up with a higher tax bill.

• As a source of income for the federal government, the estate tax is a very small portion of the overall receipts. In 2012, estate taxes made up just 0.6 percent of total federal tax receipts. By contrast, the income tax made up 46 percent, the payroll tax made up 35 percent, and the corporate income tax 10 percent. Even the profits on the assets held by the Federal Reserve make up more of the government’s income than the estate tax, at 3 percent in 2012.

  At the same time, it’s not pocket change. The Tax Policy Center estimates the estate tax will bring in about $200 billion in federal tax receipts over the next decade if the current law stays in effect.

• One strong concern that many people have about the estate tax is that their heirs will be forced to sell their family’s small business or farm in order to pay for the estate’s tax bill. The TPC estimates that a total of 20 small business or farms will owe any estate tax at all in 2013. The average effective tax rate for these estates is estimated to be about 4.9 percent of their value.

  So clients who are concerned about having enough liquid assets to pay off estate taxes and keep their family business together can use 5 percent as a rule of thumb. If they have a business to pass on to their children that is valued at $10 million, for instance, they can expect to need about $500,000 in cash or other liquid assets if they don’t want to have to sell or liquidate the business.

For more on estate planning, see:

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