How to reduce or eliminate estate taxes

Who has to pay estate taxes?

Depending on how much you own when you die, your estate may have to pay estate taxes before your assets can be fully distributed. Estate taxes are different from, and in addition to, probate expenses (which can be avoided with a revocable living trust) and final income taxes (on income you receive in the year you die). Some states also have their own death/inheritance taxes.

Federal estate taxes are expensive-in 2004 they start at 45% and quickly go up to 48%. And they must be paid in cash, usually within nine months after you die. Since few estates have this kind of cash, assets often have to be liquidated. But estate taxes can be substantially reduced or even eliminated-if you plan ahead.

Your estate will have to pay estate taxes if its net value when you die is more than the exempt amount set by Congress at that time. Here is the current schedule:

How is the net value of my estate determined?

To determine the current net value, add your assets, then subtract your debts. Include your home, business interests, bank accounts, investments, personal property, IRAs, retirement plans and death benefits from your life insurance.

Removing Assets From Your Estate

A great way to reduce estate taxes is to reduce the size of your estate before you die. So, spend some and enjoy it! Also, you probably know whom you want to have your assets after you die. If you can afford it, why not give them some assets now and save estate taxes? It can be very satisfying to see the results of your gifts--something you can't do if you keep everything until you die. Appreciating assets are usually best to give, because the asset and future appreciation will be out of your estate. Assets you give away keep your cost basis (what you paid), so the recipients may have to pay capital gains tax when they sell. But the top capital gains rate is only 15% (assets held at least 12 months). That's a lot less than estate taxes (45-48%) if you keep the assets until you die. Some of the most commonly-used strategies to remove assets from estates are explained below. Note that these are all irrevocable, so you can't change your mind later.

Tax-Free Gifts

This is easy and it doesn't cost anything. Each year, you can give up to $11,000 ($22,000 if married) to as many people as you wish. This amount is now tied to inflation and may increase every few years. So if you give $11,000 to each of your two children and five grandchildren, you will reduce your estate by $77,000 (7 x $11,000) a year - $154,000 if your spouse joins you.

You can give more, but it will use up some of your estate tax exemption. That's because it's a combined gift and estate tax exemption. While you're living, it's a gift tax exemption; after you die, it's an estate tax exemption. Charitable gifts are unlimited. So are gifts for tuition and medical expenses if you give directly to the institution.

The following are only a few of many different techniques that can be used to eliminate or reduce the estate tax burden placed upon your heirs.

1. If Married, Use Both Exemptions
o Uses both spouses' estate tax exemptions to protect twice as much from taxes---only effective if planning is put in place before either spouse dies

2. Life Insurance (Buy Through Irrevocable Life Insurance Trust)
o Can be inexpensive way to pay estate taxes
o Death benefits not included in your estate, thus doubling the amount of the benefits available for your heirs and/or to pay taxes

(Transfer Life Insurance Policies to Irrevocable Life Insurance Trust)
o Removes death benefits of existing life insurance policies from estate
o Included in estate if you die within 3 years of transfer

3. Remove Assets From Estate (Make Annual Tax-Free Gifts)
o Simple no cost way to save estate taxes by reducing size of estate
o $11,000 ($22,000 if married) each year per recipient (amount now tied to inflation)
o Unlimited gifts to charity and for medical/educational expenses paid to provider

(Qualified Personal Residence Trust)
o Removes home from estate at discounted value
o You can keep living there

(Grantor Retained Annuity Trust / Grantor Retained Unitrust)
o Removes income producing assets from estate at discounted value
o You can continue to receive income

(Family Limited Partnership)
o Discounts value of business, farm, real estate or stock thus saving gift and estate taxes
o Lets you start transferring assets to children now to reduce your taxable estate
o You keep full control

(Charitable Remainder Trust)
o Converts appreciated asset into lifetime income with no capital gains tax
o Saves estate taxes (asset out of estate) and income taxes (charitable deduction)
o Charity receives trust assets after you die

(Charitable Lead Trust)
o Removes asset from your estate, saving estate taxes
o Income goes to charity for set time period, then trust assets go to loved ones