Over the years, estate planning has been a little bit like riding a roller coaster. In 1978, the federal estate tax exemption was only $134,000 and the highest estate tax rate was a whopping 70 percent. Flash forward to 1988 and the estate tax exemption rose to $600,000 and the marginal tax rate fell to 55 percent. By 2001, the federal estate tax exemption increased to $1 million and in 2010, the federal estate tax was temporarily repealed -- but just for one year.

Today, the scene is set for you to take advantage of some tax-friendly estate planning opportunities due to the relatively generous federal gift and estate tax regime.

Not Just For the
Rich and Famous

Less than 1 percent of those who die in the U.S. will owe federal estate taxes in 2013, according to the Tax Policy Center, a nonprofit organization.

Many people think estate planning is only for the most affluent folks. But everyone with a positive net worth or minor children should think about what will happen when he or she dies.

More than Taxes

Small, simple estates typically require minimal time and money to square away. Estate plans should include:

  • Written wills or living trust arrangements;
  • Guardians for minor children;
  • Evaluations of retirement savings and life insurance products and coverage;
  • Appointments of executors and trustees (if applicable); and
  • Designations of beneficiaries for life insurance, pensions, and retirement accounts.

Proactive estate planning requires updating, especially if life situations change due to births, adoptions, deaths, marriages or divorces.

Even if your estate isn't large enough to incur a federal estate tax bill, you might incur estate or inheritance taxes at the state level, because some states' exemptions are lower than the $5.25 million federal exemption.

You also might want to set up a living (or revocable) trust for your assets to keep the details of your estate out of probate -- and make it harder for anyone to challenge your estate. Without a living trust, your estate becomes part of the public record.

Rich or middle class, you may not want your finances made public, so timely follow-through is crucial to effective estate planning. After setting up a living trust, change the titles of all assets you want to transfer to it. Another benefit: A living trust can be used to manage assets in the event you become incapacitated.

More Affluent Individuals

If your estate is worth more than $5.25 million (or $10.5 million when combined with your spouse's estate), consider making gifts that will use up some or all of your unified federal gift and estate tax exemption. That way, future appreciation in the value of assets you give away won't be included in your taxable estate.

If your assets are sold later, the gift recipient will incur capital gains tax on the appreciated value. But capital gains tax rates have historically been below estate tax rates. In 2013, the top federal capital gains tax rate (20 percent) is half the federal estate tax rate (40 percent).

But what if your estate's value hovers near the $5.25 million threshold (or $10.5 million for married couples)? Should you give away assets today -- or wait? The answer depends on your age, health, expected tax law changes, projected future value of assets, and other factors.

To illustrate, suppose you gift a $2 million vacation home to a daughter today. Assume it's your first "dip" into your $5.25 million federal gift tax exemption, so the transfer incurs no federal taxes. Assume that upon transfer, your daughter's tax basis in the house is $1 million. In ten years, your daughter sells the property for $3 million. She will owe capital gains tax on the $2 million difference between the sale price and the tax basis in the property.

Conversely, let's suppose you had willed the house to your daughter. She would receive a stepped-up basis in the house for income tax purposes at the time of your death. Therefore, her tax basis in the house would be $3 million -- and she could sell it for $3 million without incurring any federal capital gains tax.

Assets with Losses

Most assets appreciate over time, but if you own assets with losses, your estate could lose out on claiming them. That's because your heirs would receive the assets at a stepped-down basis, due to the market value on the date of death. So, consider selling assets with losses before you die.

All in the Family

Most people want their assets to pass to family members when they die. Spouses can transfer assets back and forth without incurring gift or estate taxes, as long as both are U.S. citizens. But if you want your noncitizen spouse, children, grandchildren, or extended family and friends to inherit your estate, they might have to pay taxes.

In 2013, you can transfer as much as $5.25 million of assets without incurring federal gift, estate or generation skipping transfer (GST) tax. That doesn't include the annual gift tax exclusion of $14,000 per year per donor and recipient. Estate tax is calculated on the net value of the decedent's assets as of the date of death -- or on the alternate valuation date, which is six months later.

Part of your estate plan is figuring out the optimal tools to use and timing of transfers to minimize taxes. Start by inventorying your personal assets, which may include:

  • Cash and investments;
  • Retirement accounts;
  • Your personal residence, vacation home, and other real estate;
  • Private business ownership interests;
  • Life insurance (including any death proceeds);
  • Automobiles; and
  • Personal assets, such as artwork, jewelry, and collectibles.

Then, subtract any liabilities you owe and amounts you plan to transfer to charities or your spouse. The result is your net taxable estate. If you're married, prepare a similar list for your spouse.

Next, designate the preferred recipient of each asset. To illustrate, suppose you have twin sons and two major assets -- an auto dealership and a rental property. You might transfer the dealership stock to the son who works as the service manager there. His brother, who isn't involved in the dealership, can inherit the rental property.

Estate Planning Toolkit

Outright transfers are simple and flexible. However, you can no longer control what the recipient does with the assets. Trusts are more complex, but they can be useful when heirs are immature or lack asset management capabilities. They also can help save taxes and protect assets from creditors.

Many other estate planning tools -- such as qualified terminable interest property (QTIP) trusts, Crummey trusts and family limited partnerships -- can be used to minimize tax. They may also achieve other estate planning objectives, such as professional asset management, protection against creditors' claims and preservation of the portability provision in generation-skipping transfers and remarriages.

Another way to reduce your taxable estate is with the annual gift tax exclusion. Each individual is entitled to give as much as $14,000 (up from $13,000 in 2012) per year per recipient without any gift tax consequences or using any of his or her gift, estate or GST tax exemption amount ($5.25 million for 2013).

That means a married couple can gift $56,000 to their son and daughter-in-law ($28,000 combined times two recipients). You also can pay unlimited medical and tuition expenses on behalf of family members, without incurring gift tax, if you pay the bills directly to providers. Tuition for any age child -- even certain preschools -- may qualify.

Valuing Your Estate

Asset valuations are an important part of estate planning. The value of cash and investment accounts is readily available. But valuing less marketable assets -- such as fractional interests in real estate, private business interests, stock options and patents -- requires input from a credentialed appraisal professional.

Often these assets are subject to discounts for lack of control and marketability that only a qualified valuation pro knows how to quantify. If your estate includes these assets, you may need to hire a valuator to prepare a written appraisal to support gift and estate tax returns.

It's important to monitor the value of your estate before you die. Determining the value of the individual components also can help ensure that your asset allocations to family members are equitable -- and that you're not favoring one heir over another.

Asset values also fluctuate over time. So update appraisals regularly to ensure your estate plan continues to make sense.

Beware of State Death Taxes

Quite a few states impose estate or inheritance tax at a lower threshold than the federal government does. So it's important to understand the rules in your state to avoid an unexpected tax liability or other unintended consequences of an asset transfer.

For example, in New York, the state estate tax exemption is $1 million per individual. Any assets transferred beyond the exemption are subject to an estate tax of up to 16 percent. Suppose a wealthy New York couple died in 2013, leaving their estate worth $10 million to their children. They would incur no federal estate tax (assuming they had not used any of their unified federal gift and estate tax exemptions during their lives). But the couple's estate would owe state-level estate taxes on $8 million -- the amount that the taxable estate exceeded the state exemption.

Feeling Charitable?

Charities provide another outlet for sharing your wealth -- and direct bequests to charities can also reduce your estate tax bill. Moreover, qualified charitable donations made during your lifetime generally qualify for income tax deductions.

You can create trusts to achieve your philanthropic objectives, while also minimizing taxes. For example, a charitable remainder trust (CRT) pays income to your beneficiaries for a prescribed time. At the end of that period, the remaining trust assets pass to your favorite charitable organization(s).

Alternatively, you might prefer a trust do the reverse -- provide an income for a favorite charity over a set period, with the remainder passing to your beneficiaries after the trust expires. In that case, you need a charitable lead trust (CLT).

Seek Professional Advice

Estate planning is an ongoing process with many options and nuances. Congress could pass estate tax law changes in the future that would alter the current exemptions and tax rates -- or even repeal the estate tax altogether. So it's important to be prepared for a variety of scenarios.

© Bizactions LLC.