From the Federal Citizen Information Center

How Estates Are Taxed

If you think taxes are bad while you are alive, estate taxes can be far worse if you happen to own enough assets at your death and do not have an estate tax plan. Federal estate tax law permits each taxpayer to transfer a certain amount of assets at death, free from federal estate taxes. Under the current tax law (Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, signed into law on December 17, 2010) for years 2011 and 2012 an estate tax will be assessed against those estates in excess of $5,000,000 per person. This threshold is known as the applicable exclusion amount.

Many may feel that because their estate is below the increased exclusion amount there is no need for planning. However, no one should become lulled into a false sense of complacency just because their estate may be less than the $5,000,000 exclusion. Remember, this law is for decedents dying in calendar years 2011 and 2012 only. In 2013 the exclusion amount will be $1,000,000 with a top tax rate of 55%. And because Congress can change its mind at any moment no one knows what the exclusion amount will be at their death.

Therefore, the increased exemption in 2011 and 2012 should not change your desire to prepare your assets; it is better to have a plan in place that withstands the estate tax uncertainty than to wait for the law, then plan.

The following chart shows, by year, the dollar amount of your estate excluded from federal estate taxes and the tax rate on the taxable portion of an estate. Note that rates are as high as 55% for the taxable portion of the estate.

As of 1/1/2013, the estate tax maximum rate is currently scheduled to revert to 55% unless Congress passes new legislation.

Gift Taxes

Federal gift tax law permits each taxpayer to transfer certain amounts of assets free from gift tax during their lifetimes. Current law provides for a $5 million federal gift tax exclusion.

Minimizing and Even Eliminating Estate Taxes

There are a number of estate tax planning methods you can use to minimize federal taxes on your estate.

The first order of business is to utilize the estate tax exemptions to which we are all entitled under federal law while also taking into account and utilizing state estate exemptions. Given the variety of state estate tax provisions, this brochure only discusses federal tax law.

A married couple has the ability to utilize the federal estate exemptions of both spouses. Meaning, in years 2011 and 2012, the first spouse to die can use their $5,000,000 to minimize their federal estate tax liability, and the second spouse to die can use their exemption when they die. Be mindful that the exemption only applies to assets you own in your name alone. If all your assets are owned with another person, then you cannot use the estate tax exemption to minimize federal estate taxes; other strategies may be used in this event.

Up until 2011, these exemptions were like coupons that had to be used or they were lost; hence, if your spouse was not able to use his/her exemption it would not be available to you. But with the enactment of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, exemptions may be carried over. Therefore, if your spouse does not use any or only a portion of their exemption the balance will be added to your $5,000,000 exemption. Again, this carry-over provision is only for years 2011 and 2012.

Many wills and trusts leave all assets directly to the surviving spouse ("All To Spouse Will"). Using this type of will means all assets are transferred to the surviving spouse and the estate tax is deferred until the death of the second spouse. Since there is an unlimited "marital deduction" between spouses who are U.S. citizens, there is no federal estate tax when the first spouse dies. The problem with these wills is that the married couple has lost the use of the "coupon" of the first spouse to die and the combined estate will be subject to higher federal estate taxes upon the death of the surviving spouse.

To avoid this problem, many couples utilize the exemption of the first spouse to die by establishing and funding a bypass or credit shelter trust at the time of the first death. They do this by ensuring that the will or trust of the first spouse to die contains special language that directs the creation of the bypass trust at that time. The assets of the first spouse to die will then go into the bypass trust up to the amount of federal estate tax exemption. The surviving spouse will have access to the bypass trust as well as his or her own assets. For example, if the estate of a married couple is $6 million, and the federal estate tax exemption is $5 million, bypass trust planning will enable a married couple to utilize both coupons and transfer as much as $6 million free of federal estate tax. The assets in the bypass trust will appreciate free of estate taxes, so the amount transferred to loved ones may be greater than $1 million. It is important to consider state estate tax planning when utilizing this method, and an experienced estate attorney can best help with such planning.

Giving away assets during your lifetime also will reduce your taxable estate. Federal tax law generally allows each individual to give up to $13,000 (scheduled to be adjusted periodically for inflation) per year to anyone, without paying gift taxes, subject to certain restrictions. This means you can transfer some of your wealth to your children or others during your lifetime to reduce your taxable estate. For example, you could give $13,000 a year to each of your children, and if you elect to split gifts with your spouse, a total of $26,000 per year can be given to each child. You may make $13,000 annual gifts to as many other people as you wish without having to pay federal gift taxes or utilize any of your lifetime gift tax exclusion, but amounts in excess of $13,000 will count against your lifetime gifting exemption. There are ways of reducing the "cost" of such gifts that are beyond the scope of this brochure. Gifting can be a very powerful planning tool if properly implemented.

Charitable gifts are another way you can reduce estate taxes. Any such gifts must be made to an organization that operates for religious, charitable or educational purposes and is duly qualified with the Internal Revenue Service. Consult your tax advisor for specific details.

Irrevocable life insurance trusts are used to minimize estate taxes by removing life insurance proceeds from taxable estates and to make it easier to convert your estate's assets into cash. Life insurance trusts are funded either by transferring an existing life insurance policy or by having the trust purchase a new policy. (Note that transferring an existing policy may have gift and/or estate tax consequences—consult your tax advisor). A number of complex rules must be followed to avoid inclusion in your estate. For example, such trusts must be irrevocable—meaning that you cannot dissolve the trust or change the terms of the trust if you change your mind later—and they must be properly established and administered during your lifetime.

Estate planning is subject to changing laws and can be basic or complex, according to your needs. This pamphlet does not cover all aspects of estate planning. Be sure to seek professional advice from a qualified attorney, and perhaps a CPA. The money you spend now to plan your estate can mean more money for your beneficiaries in the end.