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1. 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:
Year of Death... ... ... "Exemption" Amount
2004 & 2005... ... ... ... .$1.5 million
2006, 2007 & 2008... ..$2 million
2009... ... ... ... ... ... ... ..$3.5 million
2010... ... ... ... ... ... ... ... N/A (repealed)
2011 and thereafter... ..$1 million
2. 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.
3. How can I reduce or eliminate my estate taxes?
In the simplest terms, there are three ways:
1. If you are married, use both estate tax exemptions.
2. Remove assets from your estate before you die.
3. Buy life insurance to replace assets given to charity and/or pay any remaining estate taxes.
4. What does "Using Both Exemptions" mean?
If your spouse is a U.S. citizen, you can leave him or her an unlimited amount when you die with no estate tax. But this can be a tax trap, because it wastes an exemption.
Let's say, for example, that Bob and Sue together have a net estate of $3 million and they both die in 2004. Bob dies first. He leaves everything to Sue, so no estate taxes are due then. When Sue dies, her estate of $3 million uses her $1.5 million exemption. The tax bill on the remaining $1.5 million? $705,000!
But if, instead, Bob and Sue plan ahead, they can use both their exemptions and pay no estate taxes. A tax-planning provision in their living trust splits their $3 million estate into two trusts of $1.5 million each. When Bob dies, his trust uses his $1.5 million exemption. When Sue dies, her trust uses her $1.5 million exemption. This reduces their taxable estate to $0, so the full $3 million can go to their loved ones.
This planning can also be done in a will, but you would not avoid probate or enjoy the other benefits of a living trust.
5. How do I remove assets from my 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 include:
- Tax Free Gifts
- Irrevocable Life Insurance Trust (ILIT)
- Grantor Retained Annuity Trust (GRAT)
- Grantor Retained Unitrust (GRUT)
- Family Limited Partnership (FLP) or Limity Liability (LP or LLC)
- Charitable Remainder Trust (CRT)
- Charitable Lead Trust (CLT)
- Life Insurance
*Note that these are all irrevocable, so you can't change your mind later.
6. What do you mean by Tax-Free Gifts?
Tax-free gifts or annual tax-free gifts are easy and it doesn't cost anything to do. Each year, you can give up to $12,000 ($24,000 if married) to as many people as you wish. So if you give $12,000 to each of your two children and five grandchildren, you will reduce your estate by $84,000 (7 x $12,000) a year - $168,000 if your spouse joins you. (This amount is now tied to inflation and may increase every few years.)
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.
7. What is an Irrevocable Life Insurance Trust (ILIT)?
An easy way to remove life insurance from your estate is to make an ILIT the owner of the policies. As long as you live three years after the transfer of an existing policy, the death benefits will not be included in your estate.
Usually the ILIT is also beneficiary of the policy, giving you the option of keeping the proceeds in the trust for years, with periodic distributions to your spouse, children and grandchildren. Proceeds kept in the trust are protected from irresponsible spending and creditors, even ex-spouses.
8. What are Grantor Retained Annuity Trust (GRAT) and Grantor Retained Unitrust (GRUT)?
These are much like a QPRT. The main difference is that a GRAT or GRUT lets you transfer an income-producing asset (stock, real estate, business) to a trust for a set number of years, removing it from your estate, and still receive the income. (If the income is a set amount, the trust is called a GRAT. If the income fluctuates, it's called a GRUT.)
When the trust ends, the asset will go to the beneficiaries (usually your children). Since they will not receive it until then, the value of the gift is reduced. If you die before the trust ends, the asset will be in your estate.
9. How would setting up a Family Limited Partnership (FLP) and Limited Liability help?
Both FLPs and LLCs let you reduce estate taxes by transferring assets like a family business, farm, real estate or stocks to your children now, yet you keep full control.
For example, you and your spouse can set up an FLP or LLC and transfer assets to it. In exchange, you receive ownership interests. Though you have a fiduciary obligation to other owners, you control the FLP or LLC either through the general partner or as manager, and you can give ownership interests to your children, which removes value from your taxable estate.
The ownership interests cannot be sold or transferred without your approval. And because there is no market for these interests, their value is discounted. So you can transfer the underlying assets to your children at a reduced value - without losing control.
10. What is a CRT (Charitable Remainder Trust)? A CRT lets you convert a highly appreciated asset (like stocks or investment real estate) into a lifetime income without paying capital gains tax when the asset is sold. It also reduces your income and estate taxes, and lets you benefit a charity that has special meaning to you.
With a CRT, you transfer the asset to an irrevocable trust. This removes it from your estate. You also get an immediate charitable income tax deduction.
The trust then sells the asset at market value, paying no capital gains tax, and reinvests in income-producing assets. For the rest of your life, the trust pays you an income. Since the principal has not been reduced by capital gains tax, you can receive more income over your lifetime than if you had sold the asset yourself. After you die, the trust assets go to the charity you have chosen. 11. What is a Charitable Lead Trust (CLT)?
A CLT is just about the opposite of a CRT. You transfer an asset to the trust, which reduces the size of your estate and saves estate taxes. But instead of paying the income to you, the trust pays it to a charity for a set number of years or until you die. After your death, the trust assets will go to your spouse, children or other beneficiaries.
12. How would buying life insurance help reduce estate taxes?
Depending on your age and health, buying life insurance can be an inexpensive way to replace an asset given to charity and/or to pay any remaining estate taxes. The three-year rule mentioned earlier does not apply to new policies. But you should not be the owner of the policy - that would increase your taxable estate and estate taxes. To keep the death benefits out of your estate, set up an ILIT and have the trustee purchase the policy for you.
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