One of the most significant factors that you should consider when designing an estate plan is taxes. The act of giving away your property may be subject to taxes on the federal or state level, or both. These tax liabilities could be the largest expenses your estate may have to pay. This means the property that you want to go to your loved ones may go to the government instead. Understanding what these taxes are, how they work, how they may affect your estate, and how they can be minimized is vital to implementing a successful estate plan. While estate taxes technically refer to taxes that are imposed at death, there are two types of taxes that may affect how you plan your estate, transfer taxes and certain income taxes. Transfer taxes are imposed when you give your property to someone else. If this is done while you are alive, it is called a gift. At death, this kind of transfer is called a bequest or legacy, if you leave a valid will or an in testate succession if you don't.
A state death tax is imposed on property distributed after your death. You should be especially aware of your state's death tax because it may affect even the smallest estates. There are three types of state death tax, and every state imposes at least one type.
Taxable gifts are still reported and any gift tax owed is paid annually. Upon death, all taxable gifts are added to your gross estate for estate tax calculation purposes, even though a gift tax may have already been paid. Gift tax paid is deducted from estate tax owed, if any. The gift tax and estate tax systems are unified so that you can't avoid estate tax by giving your wealth away before you die, and you pay taxes on the cumulative amount of wealth you give away, which pushes your estate into a higher tax bracket. You need a basic understanding of the unified tax system so that you can estimate your estate tax liability and minimize your estate taxes using an estate freeze technique. An estate freeze technique is any planning device that allows you to freeze the present value of your estate and shift any future growth to your successors. Understanding how your estate tax liability is calculated and the variety of techniques you can employ to freeze your estate may help you to save your property for your beneficiaries. A large portion of your estate may go to the IRS instead of your loved ones. If you want to preserve your estate for your beneficiaries, you need to learn how to keep your property from being subject to estate taxes.
Learning techniques to freeze your estate can also reduce your estate tax liability. Under the unified tax system, you are allowed an applicable exclusion amount (formerly known as the unified credit) that reduces your gift tax/estate tax liability. There are other exclusions, deductions, and other credits available that allow you to pass a certain amount of your estate free from tax. Another method of reducing your estate tax liability is to prevent taxation of any further growth in the value of your appreciating assets. Estate freeze techniques range from relatively simple (e.g. installment sale or private annuity) to the more complex (e.g. gift- or sale-leaseback). Estate taxes must be paid within nine months of your death. In order to avoid depriving your beneficiaries of what you intend for them to receive, you should set aside sufficient assets to pay these taxes. The applicable exclusion amount for gift tax purposes is fixed at $1 million while the estate tax applicable exclusion amount increases (e.g. In 2005 it was $1.5 million). Any applicable exclusion amount you use for gift tax purposes effectively reduces the applicable exclusion amount that will be available to you at your death. In planning for estate tax expense, you should estimate what the amount of your estate taxes may be so that you can arrange to replace the wealth that is lost if you have specific gifts you would like to make.
Federal GSTT is imposed on property you transfer to an individual who is two or more generations below you. The tax code is drafted to levy a tax on property as it is passed from generation to generation at each and every level, and the purpose of the GSTT is to keep families from avoiding estate taxes by skipping an intermediate generation. A flat tax rate equal to the highest estate tax rate then in effect is imposed on every generation-skipping transfer you make over a certain amount.
There are three federal income tax considerations of which you should be aware:
Income taxation of trusts:
A trust may be a taxpaying entity. If your plan includes the use of a trust, your trustee may be required to file an annual return and pay income tax on the trust income.
Decedent's final income tax return:
If you earn income during the year in which you die, your personal representative will need to file your final income tax return and pay any income tax that may be owed. The funds to pay will come from your estate. Your tax year ends on the date of your death.
Income taxation of your estate:
Your estate is considered a separate tax-paying entity by the IRS. Your personal representative must file and pay income tax on any income your estate receives, including interest from bonds or dividends from stock.
A transfer tax is imposed when you give your property to someone else. There are six types of transfer taxes to which you or your estate may be subject.
A gift is a transfer of property you make during your lifetime. In such a transaction the giver is designated the donor, and the person or organization you give to is called the done. When you make a gift, it is in exchange for nothing, or for property of lesser value, in other words, it's not a bona fide sale. Generally, gifts must be reported and gift taxes paid in the year following the year in which the gift is made. If your state imposes a gift tax and you intend to make lifetime gifts, contact an attorney or your state's department of revenue or taxation to find out what gifts need to be reported, how to compute the gift tax, and when and how to file a gift tax return. Currently, only a few states impose a gift tax.
The GSTT is imposed on property transferred to a family member who is two or more generations below you, such as a grandchild or great-nephew. Contact an attorney or your state's department of revenue or taxation to find out what transfers may be subject to state GSTT, and when and how to file a return. Only some states impose a GSTT.
Generally speaking, federal gift and estate tax is imposed on property transferred to others either while you are living or at the time of your death. Unlike the individual states, which impose at least one type of death tax and may or may not impose a gift tax, the federal tax system is unified. The IRS adds lifetime and at death transfers and taxes them according to one rate schedule.
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