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April 6, 2014



Death and Taxes; Why Not Tax Death?

“The only things certain in life are death and taxes.”  There are few guarantees in life, but these are two of them; you will die at some point (hopefully, not soon), and you will have to pay taxes.  Of course, with such inevitability, it was only a matter of time before someone decided to tax death.  (Or rather, the money left behind after someone dies; after all, as another old saying goes, “You can’t take it with you when you die.”)

The ‘Death Tax’ Explained

There are actually two different types of taxes that are commonly called ‘Death Taxes’: inheritance taxes and estate taxes.  To understand the difference, let’s consider a hypothetical example.  Your great, great uncle Jedidiah dies, leaving a large fortune (let’s call it $10 million dollars) in his estate, a goodly amount of which is going to you (let’s say that old Jedidiah left you one tenth of his final estate).  Of course, such a fortune is high enough to be taxed; the taxes could be taken in one of two ways:

While You're Visiting Angels, Your Family Might be Facing Taxes

While You're Visiting Angels, Your Family Might be Facing Taxes

Estate Taxes: Jedidiah’s entire $10 million estate could be subject to taxes, taking a substantial portion of the money in the estate before the money is disbursed to you or any other beneficiaries.  Essentially it’s a ‘tax’ on the whole ‘estate’ (witty, no?)  Since Jedidiah is gone, it falls to whomever is administering the estate, and there is usually a single rate applied to the entire estate after any exceptions or allowances are applied.

Inheritance Taxes: In this case, Jedidiah’s fortune isn’t taxed, but the amount that you receive IS taxed.  If the entire $10 million dollar estate is disbursed, your share ends up being $1 million, on which the tax ends up being levied.  Inheritance taxes also can differ according to whom is being taxed, with direct lineal relatives being taxed the least and non-relatives facing the greatest tax rates.

There are numerous similarities between the two taxes; both types usually exempt transfers to a surviving spouse as well as charitable contributions, for example.  (The federal government only levies an estate tax, although some states tax inheritances.)

Also, it’s probably worth noting gift taxes, taxes designed to limit the amount of money transferred from one person to another while they are both still alive.  A major reason that such taxes exist is so that Jedidiah (or other persons of means) can’t give away all their money before they die in order to avoid estate or inheritance taxes, which is one reason why they are frequently grouped together in legislation.

This year is a bit odd; for 2010 (and only 2010, barring any Congressional changes to the current policy) the federal estate tax has been repealed.  It’s scheduled to make a come back in 2011, meaning that this year is likely to have some debate over whether it’s better to allow the tax to reinstate or eliminate it permanently.

The Cons and Pros of Estate and Inheritance Taxes

If you’re a long time reader of The Amateur Financier (or any personal finance publication), you probably realize that there’s going to be some argument of whether these taxes are good or bad.  For a change of pace, let’s start with the cons first:

-Inheritance or estate taxes may reduce the incentive to save.  If Jedidiah knows that up to half of his fortune will go to the government rather to his heirs, he might not make as much effort to gain more money.  Essentially, it’s the same argument against excessively high income taxes; if the tax rate is too high, the amount of income (or bequest) needed to get a net increase isn’t worth the time and effort.

-These taxes are also a form of double taxation; every dollar that gets passed onto your beneficiaries must have been earned and taxed already, so the estate and inheritance taxes are at least the second round of taxes to which the estate is subject.

-The tax adds to the complexity of the tax code.  As with any type of additional tax, there’s added paperwork and red tape to go through.  Add in the numerous ways people try to avoid the tax (by giving away their fortunes, for example) and the counter measures the government adapts (like the aforementioned gift tax), and soon the tax code gains another few volumes.

-Lastly, the argument is made that death is not the appropriate time to be collecting taxes.  The term ‘death tax’ that’s frequently attached to these types of taxes is used by many opponents to emphasize the improper timing of such taxes (and arguably, the wrongness of the tax in general).

That’s quite a list of arguments opposing inheritance and estate taxes.  Of course, if those were the only arguments, these taxes would already have been repealed.  Let’s see what’s the proponents of keeping such taxes have to say:

-Since the taxes typically fall only on the wealthiest estates (those in excess of the 1 million dollars as of 2011 assuming that the tax is reinstated), the tax is progressive, only affecting the wealthiest individuals in the country.  Many proponents argue that’s it’s a reasonable way to ensure that the overall tax system is progressive as well, preventing the wealthiest individuals in the country from dodging taxes altogether.

-Estate taxes can increase the motivation to accumulate wealth.  Though this seems like a direct contradiction of the first ‘con’ above (and it is), the fact is that different people have different motivations and will be affected differently by the existence of an inheritance tax.  One wealthy person might be demotivated near the end of their life, not wanting much of their estate to go to the government, while another might look at the tax as an obstacle to be overcome on the way to giving the amount they want to their beneficiaries.

-There’s also an argument made that the estate tax is ‘fairer’ than many other types of taxes.  Since it’s levied after the person who originally earned the money is deceased, taking money from heirs who didn’t materially contribute to earning it seems more justified.  (Opponents of the tax would argue that the government has no more (and probably less) claim on the money than do the heirs.)

-A final justification for the estate tax is pretty simple; it brings in money to the federal government.  The Center on Budget and Policy Priorities puts the ten year cost of eliminating the tax beyond 2010 at $1.3 trillion, money that will have to come from other tax revenue or be eliminated from spending (or, given how our government tends to handle such situations, just added to the deficit).

With so many different aspects to the estate tax, both in favor and opposed, it’s hard to make a blanket statement about whether it’s better to keep it repealed or reinstate it.  Not that will stop any number of commentators (myself included).  Personally, I’m inclined to think that the good outweighs the bad, although I’m betting I’m missing part of the story.

Did I miss any major effects (positive or negative) of the estate or similar taxes?  Do you think the estate tax should remain repealed?  Do you expect (or hope) to be wealthy enough to be affected by the estate tax when you pass on?

Comments

  1. I have thought about this lately as both sets of parents are doing well financially (although still young). I think death taxes are ridiculously high. One of the main reasons is passing wealth down generations can build a great industry. If I did receive a large inheritance, I would seek to make it grow. Either through sound investing (building up other businesses) or through starting my own business. This money well help to create more jobs, build infrastructure, and maybe even give my grandchildren great jobs and more wealth. I think we see an inheritance as something that will be squandered, so we tax it so much. I can see a few percentage of taxes- but it is high! Generational wealth is highly powerful.
    .-= Ted´s last blog ..The shame of debt =-.

  2. This sounds like a real lose-win for everyone subject to either death tax. Do you have any other information about gift tax limitations? Could you not give up to the gift limit to everyone in your family without penalty?
    .-= David @ MBA briefs´s last blog ..Do mass firings improve performance? =-.

  3. I have no problems with the death tax and don’t ever plan to be affected by it. Not because I won’t have enough money but because there are numerous ways to plan for it. That’s the key to this tax. It can be devastating if you are not prepared to handle it but it can easily be managed when taken into account.
    It might be worth noting that the biggest instance of double taxation is when you die with substantial monies in IRA accounts. These monies haven’t been taxed yet and the pre-tax values are used for estate tax implications. Think about that.
    .-= Evolution Of Wealth´s last blog ..Pricing Your Disability Insurance =-.

  4. This is probably the best round up of the pros and cons associated with the estate tax. When asked I often say that it is the perfect tax…it effects next to no one and those that it does effect can’t bitch that much because they are worth in the top 1 to 2% of all Americans.

    David if you were looking for gift tax info:
    http://www.myjourneytomillions.com/articles/gift-laws-taxes-simple/

  5. Aaron @ Clarifinancial says:

    I’m with Evan on this. Not only is the list of pros and cons complete (although I would add one about generational wealth being good and another about it being bad), but you also point to the fact that people should plan for estate taxes and inheritance tax. I really appreciate how neutral this is and may point to it later as a resource.

    • Wow, quite the response to what I thought was a rather wonkish post. I’ll have to do more of these, it seems.

      @Ted: You do raise a good point about generational wealth; if it passes to heirs who can use it well, the money can do a great deal to build up a family into something truly powerful. On the other hand, it can also end up being squandered by mismanagement and greed by those same heirs. My take is this: at most, the estate tax in the US takes about 50% of the inherited wealth that gets passed on. If the heirs of a great fortune don’t have skill needed to turn $5 million (after the tax) back into $10 million, why would it be any easier for them to turn the original $10 million into $20 million?

      @David: True, it is something of a lose-win situation. If you’re looking for more information on the gift tax and its rules, the post Evan has is a good start, as is this site: http://www.savewealth.com/planning/estate/taxes/ The nutshell version goes mostly like this: you can give up to $13,000 (in total value of gifts, not just money) per year to each recipient without having to pay any taxes. (Not counting gifts to spouses, charitable donations, and gifts used for medical gifts or tuition.) Above that amount, any gifts you give will eat into the $1 million gift tax exemption, the amount you can give away during your lifetime without paying the gift tax. When that exemption has been exhausted, your gift recipient will have to pay the gift taxes on the gift. (Of course, all this applies to years other than 2010; this year is weird, with gift and estate taxes being repealed for one year only.)

      @Evolution of Wealth: Very true; there are plenty of ways to avoid the estate tax (or at least, greatly soften its blow) if you know what you’re doing, or have access to advisers who can point you in the right direction. One of the disadvantages of levying a tax on the very people who have the most resources to find loopholes (to say nothing of ensuring that the loopholes are there) is that they can do a very good job of avoiding the taxes. I’ll admit, the taxation of inherited IRAs seems pretty painful; taxing pretax values at estate tax rates is downright tough.

      @Evan: Thanks for the link; it does a great job summing up the gift tax in a very concise manner. I do agree about the estate tax, as well; it’s awfully hard for those who are leaving fortunes in excess of one million dollars to garner much sympathy from the bulk of the public.

      @Aaron: If I had thought about generational wealth when writing this article, I might have mentioned it, although, it’s such a tricky subject (as you mentioned, it has its good points and bad points, so I’d need another two paragraphs or so just to bring it up) that I’m not sure it would add much to the discussion. Plus, we covered it decently here in the comments, so it didn’t go completely amiss. Thanks for the comments, and I’m glad you think it can serve as a resource in the future!

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