Image: Tax form © Brian Hagiwara,Brand X,Corbis

For tax purposes, dying this year might constitute a huge savings strategy.

We all know about the income tax. That's Uncle Sam's share of your annual wealth accumulation. It's the annual April 15 government grab of a piece of your salary, rents, interest, dividends, etc. The more you make, the bigger the slice the feds want.

But, it's not the only tax the Internal Revenue Service may hit you with.

The income tax is a tax on the accumulation of wealth. There's a second tax on the transfer of that wealth. If the person doing the tranferring is alive, we call it the gift tax. At death, it's called the estate tax. Both are taxes on the transfer of wealth.

Those taxes can be heavy. The top rate this year is 35%, and it's scheduled to go to as high as 55% in 2013.

The basic rules for transfer taxes are simple. There is no transfer tax on anything gifted or left to a spouse. Transfers to anybody else are fair game. Here's where the planning gets fun.

Annual exclusion

You can gift as much as $13,000 per person ($14,000 for 2013) without any transfer-tax liability. You don't even have to file a gift-tax return (IRS Form 709). The exclusion is based on a calendar year. So you can gift $13,000 on Dec. 31 this year and an additional $14,000 the next day -- Jan 1, 2013 -- to the same person and not even have to file a return. The best part is that you can do that with unlimited beneficiaries, as long as your cash holds out. But if you gift more than $13,000 to any one individual, you have to file that gift-tax return.

Lifetime exclusion

Just because you have to file a return, that doesn't necessarily mean you owe any transfer tax. There's a lifetime exclusion in addition to your annual exclusion. For 2012, your lifetime exclusion is $5.12 million. That means that a husband and wife can transfer as much as $10.24 million without having to pay a penny in transfer taxes. And that doesn't include the annual exclusion amounts.

You use your lifetime exclusion to shelter any gift taxes in excess of the annual exclusion. Anything left over can be used to shelter any potential estate taxes. Under current law, if an estate-tax return (IRS Form 706) is filed for the first spouse to die, any unused lifetime exclusion becomes available to and usable by the surviving spouse.

So if the husband dies in 2012 (without any prior taxable gifts) and leaves 100% of his wealth to his spouse, none of his $5.12 million exclusion is used up and all of it becomes available to the widow, in addition to her own exclusion at the time of her death. There's a catch here, though. In order to get the unused lifetime exclusion, the estate-tax return must be filed -- even if no tax is due.

Limits set to drop dramatically

The lifetime exclusions should shelter most of us from any transfer taxes. Unless Congress acts before year's end, though, the lifetime exclusion will fall to only $1 million on Jan. 1, 2013. There would still be no tax on transfers between spouses, but a whole lot more would get sucked out in taxes before the kids or any other heirs get any money.

If you add the value of your house (hopefully paid off prior to your death), investments, retirement plans and other assets, it's not that hard to get to $1 million. And that's where not knowing the rules can get you in trouble.

Congress has to act. I don't want to get on a rant here, but last session, our Congress showed all the character of an egg yolk frying on the asphalt behind my grandfather's barn on a hot summer day.

What you can do

Assuming Congress doesn't act, what should you do? Begin by removing any life insurance from your estate. If you own the policy, it's in your estate and potentially taxable. Create an irrevocable life insurance trust, designating it as the owner and beneficiary of the policy. You "real" beneficiaries (spouse and kids) would then be the beneficiaries of the trust.

You can use both the annual exclusion and the current lifetime exclusion of $5.12 million to shelter any gifts made before year's end. These current sheltered gifts would reduce your future estate value. Before you make that move, though, you should consider not only whether you're ready to give up control of the assets, but also whether your beneficiary is psychologically ready and able to take over ownership and control. One of you may not be ready for that step.

You should also examine the potential benefits of a family limited partnership to reduce the taxable value of the assets transferred via the partnership's use of discounts based on marketability and lack of control. This strategy also offers potential income tax advantages and asset protection, and it removes all potential appreciation in the transferred assets from estate-tax liability.

There are many additional techniques for reducing your potential estate. It's in your best interest to sit down with a CPA, tax attorney, financial planner etc., to examine your options and do some planning. Remember, people don't plan to fail, they fail to plan.

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