Although the primary goal of any estate plan is to determine who will receive your estate assets upon your death, a common secondary goal is the mitigation of exposure to estate taxes. Understanding the basics of the federal gift and estate taxes will likely provide you with a strong incentive to create or update your estate plan.
At the time of your death, all of your estate assets must be located and valued. The cumulative value of all your estate assets is then potentially subject to federal (and in some cases state) gift and estate tax. Before we can determine if your estate will owe any tax though, we must consider the “gift” portion of the gift and estate tax. To the cumulative total of all estate assets owned by you at the time of death you must also add the value of any qualifying lifetime gifts. If the total of all lifetime gifts and estate assets exceeds the lifetime exemption limit, then your estate will owe estate taxes.
The lifetime exemption limit for the purposes gift and estate taxes is set at $5 million, adjusted for inflation each year. As of 2013, the limit is $5.25 million, meaning that the portion of your gifts and estate assets that exceed $5.25 million will be taxed at a rate of 40 percent.
To better understand how this works, consider that you have an estate valued at $4.5 million at the time of death. So far so good – except that you also made qualifying gifts totaling $2 million during your lifetime. This brings the total for gift and estate tax purposes to $6.5 million, exceeding the lifetime limit by $1.25 million. At the rate of 40 percent, your estate would then lose $500,000 to gift and estate taxes.
If you are a widow or widower, you may be entitled to use any remaining unused portion of your deceased spouse’s lifetime exemption amount to further minimize your gift and estate tax exposure. Known as “portability,” this could allow you to avoid taxes altogether under the above scenario if your deceased spouse used less than $4 million of his or her lifetime exemption amount at the time of death.
It should be clear by now that for anyone with a moderate to large estate, gift and estate tax avoidance is a crucial, and often complicated, component of any estate plan. Failing to plan ahead can result in your family and loved ones losing out on estate assets that were intended for them but that must be used to pay a tax bill that could have been avoided with careful estate planning.
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