Avoiding the Estate Tax Collector

In order to pass on your wealth to your chosen beneficiaries at death, in addition to probate and other estate settlement costs, you (or more correctly, your estate) may have to pay death taxes at the federal level, and possibly also at the state level.

Death taxes come in two main varieties: estate taxes and inheritance taxes. The federal government, and many states, currently have estate taxes which tax the estate before it is distributed. Some of the other states impose an inheritance tax. Many variations exist among the federal law and the different state laws regarding amounts excluded from tax, effective dates, and other nuances.

Federal estate tax. We will focus here on the federal estate tax because it is potentially applicable to you no matter where you live, while state tax liability can vary widely.

Actually, although there is a separate federal estate tax, tax liability is computed on the basis of what is called the federal unified transfer tax. The unified transfer tax is made up of three distinct, but closely related, taxes:

• the estate tax,
• the gift tax and
• the generation skipping transfer (GST) tax.

Both the federal gift tax and the GST tax have their own sets of rules and planning strategies, but for purposes of this discussion, we'll only briefly introduce them and point out their main purpose: to prevent avoidance of the estate tax. Without the gift and GST taxes, individuals — particularly wealthy individuals — could get out of paying the estate tax by making lifetime transfers.

The unified transfer tax is computed with reference to the value of the property that is considered to be in your gross estate at death, plus the value of taxable gifts that you made during your life. Generally, if the total of your lifetime taxable gifts and the value of the property that you own as of the date of your death exceeds $5 million ($5.25 million as adjusted for inflation, for decedents dying in 2013), an estate tax liability may be owed on the excess value, at a 40% maximum rate.

Recent tax changes have made the estate tax permanent. The estate tax had previously been subject to a "sunset" provision which made its future difficult to predict, especially from a planning perspective. As a result of these changes, however, the estate tax is no longer scheduled to sunset. It applies now at a top tax rate of 40 percent. The spousal portability feature, for deaths after 2010, has also been made permanent.

However, if your gross estate exceeds the limit for exclusion from estate tax, all is not lost! There are many deductions and strategies available to reduce or eliminate the estate tax liability. Here's what you need to consider:

• the marital deduction
• the charitable deduction
• credit shelter bequests
• lifetime gifts
• trusts
• life insurance
• powers of appointment
• the special use valuation
• deferred payment of estate tax
• alternate valuation date
• generation-skipping transfer tax