How to Lower the taxes on my estate?

"You've got to plan now to spare your heirs' legacy from future taxes.

The biggest estate-planning mistake you can ever make is assuming that death taxes are only a concern for multi-millionaires.

When you consider the sum total of your estate -- your house, investments, the death benefit of your life insurance policy and the money that's accrued in your retirement plans -- it's easy to see why Uncle Sam is tempted to stake its claim.

Your estate escapes federal tax only if the assets you leave at death plus the taxable gifts you made during your lifetime do not exceed the exemption amount in effect the year you die. Under current law, the estate exemption for what you leave heirs when you is $2 million in 2006 through 2008, and goes to $3.5 million in 2009. After that, the estate tax will be repealed for one year and then the exemption will revert to $675,000 in 2011 unless Congress extends the repeal or changes the exemption amount. The limit for tax-free gifts you can make over your lifetime is $1 million. (That's above the $11,000 you can give per person per year tax free.)

Negotiating the tax law is always complex, and a poorly crafted estate plan can wreck your good intentions. Here are three common pitfalls.
Mistake No. 1: Owning assets jointly

It's natural for married couples to own family assets, such as a house, investments and other personal items, in both names. But by doing so, it could cost your heirs an extra seven-figures on the tax bill.

"This is the single most common mistake we see couples make," said New York City estate-planning attorney Michael Kutzin. Fortunately this is one that may not be too difficult to prevent.

By divvying up the jointly held property, you and your spouse can take full advantage of the estate-tax exemption to which you are each entitled.

Let's say a husband and wife together own assets valued at $4 million and neither owns anything else in their own name. If those assets are owned jointly with rights of survivorship, the surviving spouse would retain full ownership of the assets when he or she is widowed.

Say the husband dies in 2006 and all assets automatically pass to his wife. Effectively the husband hasn't used any of the estate tax exemption to which he's entitled. Should his wife die later the same year and her estate is still worth $4 million, her exemption will protect only $2 million from the tax man.

A tax-smart strategy would have been to split the family assets down the middle while both spouses were alive and bequeath them to someone other than their better half. Thus each spouse would have gotten to use the full $2 million exemption, effectively doubling what they could pass to their children free of federal estate tax.
Mistake No. 2: Leaving everything to your spouse

You might also squander your own exemption by leaving everything to your spouse. When you die, the so-called marital deduction lets your spouse inherit all you own tax-free -- be it $1 million or $6.5 million. But again, when your spouse dies, only that part of his or her estate that does not exceed the estate tax exemption will escape federal estate tax.

So if a husband dies with a $3 million estate and leaves everything he owns to his wife, he doesn't make use of his exemption. Should his wife die in 2006, only $2 million of her estate will pass to her heirs free of federal estate tax.

A better strategy is to build into your will a credit-shelter trust (also commonly called a bypass trust or family trust). You bequeath to the trust an amount up to the estate-tax exemption and name the trust's beneficiaries. You get to set the terms of the trust however you wish -- for example, you might name your wife as trustee and give her the right to spend all trust income plus some of the principal for unexpected expenses, like medical bills. When your spouse dies, any assets in the trust can go to your kids (or any other beneficiary) tax-free; plus your spouse's full estate-tax exemption is still available to shelter any assets remaining outside of the trust.
Mistake No. 3: Dying with life insurance in your estate

A life insurance policy is one of the best gifts to bestow during your lifetime for two reasons: First, any gift tax you may incur is based on the policy's cash value, which is generally far less than the death benefits. And those death benefits, although usually exempt from income tax, are fully subject to estate tax if you, the insured, own the policy at the time of your death.

Second, the sooner you purge this potentially huge asset from your estate, the less chance it will come back to haunt you. That's because if you die within three years of handing off your policy, the full death benefit is added back to your estate.

The simple way to get the policy out of your estate is to make it a gift to the policy's beneficiary, say your child, said estate planning attorney Randell C. Doane, coauthor of "Death and Taxes: The Guide to Family Inheritance Planning." Your child would then be both owner and beneficiary of the policy even though the policy still insures your life. But, remember, you must live at least three years after making the gift -- otherwise the policy will be treated as part of your estate. And the life insurance benefits may be subject to estate taxes depending on the its value.

There is another way to remove the policy from your estate that is a bit more complicated but also offers you and your heirs more flexibility. Many estate planners recommend that you transfer ownership of the policy to an irrevocable life insurance trust (ILIT). You can name your favorite heirs -- say your children and surviving spouse -- as beneficiaries of the trust. When you die, the death benefits will be paid to the trust and the money can pass to your beneficiaries free of income and federal estate tax. But you can set the terms under which your heirs are paid.

For instance, you may stipulate that your son only be paid if he has completed college or after he turns 30. Or you can stipulate that your surviving spouse be entitled to the income generated by the trust but not the principal.

An ILIT also can be a useful source of liquidity in cases where you leave heirs an illiquid asset such as a business. The business might take awhile to sell, and in the meantime your heirs will have to pay operating expenses, not to mention estate taxes. If they don't have cash on hand, they might have to have a fire sale just to meet the bills. Proceeds from an ILIT can help them meet or exceed those expenses and tide them over until they find a buyer for the business."


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