In order to pass on your wealth to your chosen beneficiaries at death, in addition to probate and other estate settlement costs, you (or more correctly, your estate) may have to pay death taxes at the federal level, and possibly also at the state level.
Death taxes come in two main varieties: estate taxes and inheritance taxes. The federal government and three states (Montana, Ohio and Oklahoma) currently have estate taxes which tax the estate before it is distributed. The following thirteen states impose an inheritance tax: Connecticut, Indiana, Iowa, Kentucky, Louisiana, Maryland, Montana, Nebraska, New Hampshire, New Jersey, Pennsylvania, South Dakota and Tennessee.
You should be aware that 47 states (and the District of Columbia) impose what is usually called a "pick-up" estate tax. Although there are different variations of this tax, it is generally designed to tax state residents in an amount that equals the credit that the federal estate tax allows for state death taxes paid. So, if a state resident doesn't have a federal estate tax liability, he shouldn't have a liability under a state pick-up tax. In effect, what the pick-up taxes do is to take a portion of the federal estate tax (usually a rather modest portion) and transfer it to the states. Except for having to file another tax return, a state pick-up tax should have little impact on your estate.
Federal estate tax. We will focus here on the federal estate tax for two reasons: (1) it is potentially applicable to you no matter where you live, and (2) its rates are significantly higher (18 percent to 55 percent in 2001) than that other tax that we all love to hate, the income tax (with its 10 percent to 39.1 percent rates for individuals in 2001).
Actually, although there is a separate federal estate tax, tax liability is computed on the basis of what is called the federal unified transfer tax. The unified transfer tax is made up of three distinct, but closely related, taxes: the estate tax, the gift tax and the generation skipping transfer (GST) tax. Both the federal gift tax and the GST tax have their own set of rules and planning strategies, but for purposes of this discussion, we'll only briefly introduce them and point out their main purpose: to prevent avoidance of the estate tax. Without the gift and GST taxes, individuals — particularly wealthy individuals — could get out of paying the estate tax by making lifetime transfers.
The unified transfer tax is computed with reference to the value of the property that is considered to be in your gross estate at death, and to the value of taxable gifts that you made during your life. Generally, if the total of your lifetime taxable gifts and the value of the property that you own as of the date of your death exceeds $675,000 (for 2000 and 2001), a transfer tax liability may be owing on amounts that exceed this figure. If this tax applies, it will be steep: the lowest effective tax rate that will apply is 37 percent!
The estate tax exemption will rise to $1 million in 2002-2003, $1.5 million in 2004-2005, $2 million in 2006-2008, and $3 million in 2009. After that, the estate tax will be repealed altogether for one year in 2010.
But even if your estate is too large to fall within the exemption amount, all is not lost! There are many deductions and strategies available to reduce or eliminate the transfer tax liability. Here's what you need to consider: