Death and taxes: Reducing estate taxes

1. If you're married, use both estate tax 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 $2.5 million and they both die in 2004. Bob dies first. He leaves everything to Sue, so no estate taxes are due then. When Sue dies, her estate of $2.5 million uses her $1.5 million exemption, still leaving $1 million to be taxed.

But if Bob and Sue use both of their exemptions, they pay no estate taxes. A tax-planning provision in their living trust splits their $2.5 million estate into two trusts of $1.25 million each. When Bob dies, his trust uses his $1.25 million exemption. When Sue dies, her trust uses her identical exemption. This reduces their taxable estate to zero, so the full $2.5 million can go to their loved ones.

2. Remove assets from your estate before you die
Another great way to reduce estate taxes is to reduce the size of your estate before you die. So, live it up a little and enjoy life while you can!

Since you probably know where you want your assets to go after you die, give them away now if you can afford it. Appreciating assets are usually best to give, because the asset and future appreciation will be out of your estate.

Assets you give away retain your cost basis (what you paid), so the recipients may have to pay capital gains tax when they sell. But the top capital gains rate it still a lot less than estate tax rates that could apply if you hold the assets until you die.

3. Make annual tax-free gifts
Each year, you can give several thousand dollars to as many people as you wish and this will reduce your eventual taxable estate. Currently, the annual gift exclusion amount is $11,000 per person. (This amount is adjusted for inflation, so it could increase slightly in coming years.) So if you give $11,000 to each of your two children and five grandchildren, you will reduce your estate by $77,000 (7 x $11,000) a year -- $154,000 if your spouse joins you.

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, as are gifts for tuition and medical expenses if you give directly to the institution.

4. Use life insurance
Buy life insurance to pay remaining estate taxes and then transfer it to an Irrevocable Life Insurance Trust. As long as you live three years after the transfer, the death benefits will not be in your estate. Usually the trust is also a beneficiary of the policy. So when you die, the money can provide for your spouse, children or others according to the instructions you put in the irrevocable life insurance trust when it was established.