When you die, your property may be taxed both before and after it is distributed to your beneficiaries. A well-written last will and testament combined with smart tax strategies can considerably reduce the tax burden on both your estate and your beneficiaries. Estates can be taxed at both the state and federal level, and state tax laws vary somewhat from state to state.
The Estate Tax
The federal government and some states impose a tax on the net value of your estate when you die. Exemptions apply to both federal and state estate taxation, however. Although the exemption varies widely from year to year, you are not likely to pay estate tax unless the net value of your estate is several million dollars. If your estate is subject to the estate tax, only the portion exceeding the exemption will be taxable.
Avoiding Tax With a Trust
One way to avoid estate tax is to establish an irrevocable living trust before you die and place some of your assets into the trust. When you die, the trust's assets will not go through probate, pass under your will or be counted as estate assets for purposes of assessing estate tax.
Avoiding Tax With Gifts
Another way to avoid estate tax is to make gifts to your beneficiaries before you die instead of making bequests in your will. You can make tax-free gifts to beneficiaries during your lifetime up to a statutory maximum. The limit was $13,000 per beneficiary at date of publication. If your gift exceeds the maximum, you may have to pay gift tax on the amount of the gift that exceeds the maximum, although your beneficiaries will not be taxed on the gift. In most cases, a gift of any size to your spouse is tax-free.
Taxation of Beneficiaries
Generally, beneficiaries under your will are not taxed on the value of property they inherit from you, although the amount available for inheritance may be reduced if your estate pays estate tax. If inherited property appreciates in value, however, your beneficiary may have to pay capital gains tax if he sells it. Capital gains tax is normally based on the increase in value of a capital asset -- such as a house or a share of stock -- between the time it is bought and the time it is sold. If you bequeath property to a beneficiary, however, and your beneficiary later sells the property, he will be taxed only on the increase in the value of the property from the date of your death until the date he sells the property. No capital gains tax is assessed on the increase in value of the property between the day you buy it and the day you die. For this reason, consider bequeathing capital assets under your will rather than selling them while you are still alive and leaving the sale proceeds to your beneficiaries.
Tax laws change from time to time. The estate tax exemption is particularly unstable, for example. In addition to tax law changes, the value and contents of your estate are likely to change between the time you write your will and the time you die. For this reason, it is important to keep up with changes in tax law and your estate, and to execute a codicil (revision) to your will when necessary or desirable.