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Understanding
Estate Taxes
Strategies To Reduce Or Eliminate Your Estate Taxes
1. Who has to pay estate
taxes?
2. How is the net value of my estate
determined?
3. How can I reduce or eliminate my
estate taxes?
4. Using Both Exemptions
5. Removing Assets From Your Estate
6. Tax-Free Gifts
7. Irrevocable Life Insurance Trust
(ILIT)
8. Qualified Personal Residence Trust
(QPRT)
9. Grantor Retained Annuity Trust (GRAT)
and Grantor Retained Unitrust (GRUT)
10. Family Limited Partnership (FLP)
11. Charitable Remainder Trust (CRT)
12. Charitable Lead Trust (CLT)
13. Buying Life Insurance
14. How To Reduce or Eliminate Estate
Taxes Summary Chart
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--they now
start at 41% and quickly go up, to 49% in 2003. 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
2006,
2007 & 2008....$2 million
2009........................$3.5 million
2010........................N/A (repealed)
2011........................$1 million
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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.
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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 pay remaining estate taxes.
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4. Using
Both Exemptions
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 $2 million and they both
die in 2003. Bob dies first. He leaves everything to
Sue, so no estate taxes are due on his death. When Sue
dies, her estate of $2 million uses her $1 million
exemption. The tax bill on the remaining $1 million?
$435,000!
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 $2 million estate into two trusts of $1 million
each. When Bob dies, his trust uses his $1 million
exemption. When Sue dies, her trust uses her $1 million
exemption. This reduces their taxable estate to $0, so
the full $2 million can go to their loved ones. A
$435,000 savings!
If you are married and qualify for the family
business deduction, this arrangement will let you and
your spouse leave your family up to $2.6 million estate
tax-free.
This planning can also be done in a will, but
you would not avoid probate or enjoy the other benefits
of a living trust.
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5.
Removing Assets From Your Estate
An effective 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 to whom you want to
direct 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 the original 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%) 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.
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6.
Tax-Free Gifts
This is easy and it doesn't cost anything. 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; or
$154,000 if your spouse joins you. (This amount is now
tied to inflation and may increase from year to year.)
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.
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7. 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, the death
benefits will not be included in your estate. Usually
the ILIT is also the beneficiary of the policy. When you
die, the money can provide for your spouse, children or
others according to the instructions you put in the ILIT
when you set it up.
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8.
Qualified Personal Residence Trust (QPRT)
A QPRT lets you save estate taxes by removing your home
(a substantial asset) from your estate now; yet you can
continue to live there. Here's how it works.
You transfer your home to a trust for a period
of time, usually 10 to 15 years. During this time, you
continue to live in your home. When the trust term ends,
title to your home transfers to the trust beneficiaries,
usually your children. If you wish to stay there longer,
you may make arrangements to pay rent. If you die before
the trust ends, your home will be included in your
estate, just as it would had you never set up a QPRT.
There's more. A QPRT "leverages" your estate
tax exemption. Since your children will not receive the
house until the trust ends, its value as a gift is
reduced. For example, if the current value of your home
is $250,000 and you put it in a QPRT for 15 years, its
value for tax purposes could be as little as $75,000.
That leaves much more of your exemption for other
assets.
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9. 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
fixed 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 for tax-planning purposes, which is an advantage
for you. If you die before the trust ends, the asset
will be in your estate.
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10.
Family Limited Partnership (FLP)
An FLP lets you reduce estate taxes by transferring
assets such as a family-owned 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 and transfer assets to it. In exchange, you receive
partnership shares. You control the general partner
shares and can give limited partner shares to your
children, removing up to 99% of the value of the assets
from your taxable estate.
Because you control the general partner shares,
you have full control of the FLP. Limited partners (your
children) have none. Their shares cannot be sold or
transferred without your approval. And because there is
no market for these shares, their value is highly
discounted. So you can transfer the assets to your
children at a reduced value—without losing control.
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11.
Charitable Remainder Trust (CRT)
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 the asset from your
taxable estate. You also receive 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, paid the capital gains tax, and then
reinvested the smaller amount. After you die, the trust
assets go to the charity you have chosen.
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12.
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
taxable estate. 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. Then the trust assets will go to your
spouse, children or other named beneficiaries.
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13.
Buying Life Insurance
Depending on your age and health, buying life insurance
can be an inexpensive way to pay estate taxes. Also, the
three-year rule mentioned earlier does not apply to new
policies. But don't be the owner of the policy—that will
increase your taxable estate and your estate taxes. To
keep the death benefits out of your taxable estate, set
up an ILIT and have it purchase the policy for you.
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14. How To Reduce or Eliminate
Estate Taxes Summary Chart
a. If Married, Use Both Exemptions
(Living Trust with Tax Planning)
• Uses both spouses' estate tax exemptions
• Protects up to $2.6 million from estate taxes (for
family businesses that qualify)
b. Remove Assets From Estate
(Make Annual Tax-Free Gifts)
• Simple, no-cost way to save estate taxes by reducing
size of estate
• $11,000 ($22,000 if married) each year per recipient
(amount now tied to inflation)
• Unlimited gifts to charity and for medical/educational
expenses paid to provider
(Transfer Life Insurance Policies to
Irrevocable Life Insurance Trust)
• Removes death benefits of existing life insurance
policies from estate
• Included in estate if you die within 3 years of
transfer
(Qualified Personal Residence Trust)
• Removes home from estate at discounted value
• You can keep living there
(Grantor Retained Annuity Trust / Grantor
Retained Unitrust)
• Removes income-producing assets from estate at
discounted value
• You can continue to receive income
(Family Limited Partnership)
• Discounts value of business, farm, real estate or
stock
• Lets you start transferring assets to children now to
reduce your taxable estate
• You keep full control
(Charitable Remainder Trust)
• Converts appreciated asset into lifetime income with
no capital gains tax
• Saves estate taxes (asset out of estate) and income
taxes (charitable deduction)
• Charity receives trust assets after you die
(Charitable Lead Trust)
• Removes asset from your estate, saving estate taxes
• Income goes to charity for set time period, then trust
assets go to loved ones
c. Buy Life Insurance
(Through Irrevocable Life Insurance Trust)
• Can be inexpensive way to pay estate taxes
• Death benefits not included in your estate
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NOTE: This
information is designed to provide a general
overview with regard to the subject matter
covered and is not state-specific. The authors,
publisher and host are not providing legal,
accounting or any other advice which purports to
be specific to your situation. The contents of
this website are believed to be completely
reliable. Nevertheless, some material may be
affected by changes in the laws or
interpretations of such changes since the
material was entered on the website. If legal
advice or other expert guidance is required, the
services of a competent professional in the
field of law, accounting, insurance or
investments should be sought.
Price
& Farrington, PLLC - Attorneys and Counselors at
Law
Parkwood Office Center - 2370 130th Ave. N.E., Suite
103 - Bellevue, WA 98005
Phone: 425.451.3583.. Fax:
425.452.0153 ..E-mail: contact@pricefarrington.com
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