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If you have been fortunate enough to accumulate substantial assets during your lifetime, do you know that estate taxes may reduce the amount you'll be able to pass on to your heirs. For estates larger than $1,500,000 in 2005, federal estate tax rates can reach as high as 47%. Therefore, it is very important to develop an estate planning strategy that helps reduce the impact of estate taxes. By making gifts of existing assets during your lifetime, you may be able to reduce the size of your estate and lessen your family's future estate tax burden.

Gift-Giving Basics

1) The annual gift tax exclusion allows a donor to give away up to $11,000 (subject to inflation indexing), per calendar year per recipient without incurring a gift tax liability. If the donor is married and his or her spouse consents to "splitting" the gift, the annual gift tax exclusion increases to $22,000, even if only one spouse actually makes the entire gift.

2) Making gifts during one's lifetime shifts future appreciation of gifted property to the recipient.

3) Taxable income may be shifted from the high tax bracket of a donor to the lower tax bracket of a recipient, age 14 or older.

4) No gift tax is paid out-of-pocket until taxable gifts exceed the $1,000,000 lifetime gift exemption. The federal gift tax is cumulative. If the gift qualifies for the annual gift tax exclusion, it does not count against your lifetime exemption. One potential disadvantage of lifetime gifts is that they do not qualify for the "step-up" in basis to the fair market value of the asset at the time of your death. This step-up in basis—the amount originally invested to purchase the asset—would allow your heirs to avoid owing capital gains tax on any increase in value of the asset between the time of purchase and your death.

What About Life Insurance Gifts?

For many individuals, life insurance can be a significant asset in their gross estate. If your total estate is large enough to incur federal estate taxes, you may wish to consider how to shield the death benefit proceeds from federal estate tax liability. If, at your death, you own a life insurance policy, the death benefit proceeds will be included in your gross estate and could be subject to federal estate taxes (depending on the size of your estate).

An irrevocable life insurance trust (ILIT) can be set up to be the owner and beneficiary of a new policy. The use of this type of trust has been widely regarded as an effective means for keeping life insurance policies from the taxable estate of the insured. When properly drafted, this trust can eliminate the death benefit proceeds not only from your gross estate, but also from the gross estate of the trust's beneficiary.

If you plan to use an existing policy, you must live for more than three years following the transfer to the ILIT. Otherwise, the policy proceeds will be included in your taxable estate. Also, keep in mind that if the transferred policy has a cash value, a federal gift tax may apply (Treas. Reg. Sec. 25.2512-6). For a new policy, the trust should be designated as the owner, applicant, and beneficiary.

An outright gift is another method of removing life insurance from your gross estate. You can accomplish this by gifting ownership of your policy to a third party (such as a child or favorite charity). Federal gift tax may be incurred, if the transferred policy's value exceeds the annual exclusion allowance, but not if the new owner is a qualified charity. Please bear in mind, as is the case with any transfer of policy ownership, the insured donor must live for more than three years after the transfer. If the donor dies within three years of the transfer, the proceeds of the policy will be included in the gross estate of the insured decedent (but offset by a charitable deduction if the transfer was to a charity).

The use of a tax reduction technique such as gift giving, can have a positive effect on the reduction of the size of your estate. However, as with all tax planning matters, a qualified professional should be consulted to help ensure planning decisions are consistent with your overall goals and objectives. $

Note: The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) gradually reduces the estate tax, ultimately repealing it in 2010, but only for one year. A “sunset” provision included in the legislation nullifies all changes as of January 1, 2011. Unless Congress takes additional legislative action, the estate tax will revert to its status prior to EGTRRA.

In order to enjoy your retirement, you should have a good idea of how much money will be needed each year to fund your desired lifestyle. To help ensure that lifestyle, you will need to set aside enough money to supplement known sources of retirement income, such as a company pension and Social Security. Finally, it is important to be aware of how your age can affect your retirement decision-making. Here are some important age milestones to consider:

Age 55. If you take "early" retirement, quit, or are otherwise terminated from employment, you can generally withdraw money from 401(k), 403(b), Keogh, SEP (Simplified Employee Pension), and profit-sharing plans without being subject to a 10% federal income tax penalty for early withdrawals. In order to meet the qualifications as specified in IRS Publication 575: The individual must attain age 55 by December 31st of the year he or she leaves the workforce; money must stay in and come from the employer's plan and cannot be transferred to an Individual Retirement Account (IRA); early withdrawals are subject to the plan's provisions; and only money from your last employer's plan will qualify (not funds from previous employers). You may take early distributions from a traditional IRA without penalty, provided you receive "substantially equal periodic payments." Certain rules govern this provision, so seek the appropriate counsel.

Age 59½. Generally, you can withdraw money from traditional IRAs and qualified retirement plans after the age of 59½ without being subject to the 10% penalty tax if plan-specific qualifications are met. Ordinary income tax will be due if your contributions were tax deductible. No income tax or penalty will apply to distributions from a Roth IRA provided you have reached age 59½ and have owned the account for at least five years.

Age 60. Widows and widowers are eligible for Social Security benefits.

Age 62. Some companies may allow retirement at this age with full pension benefits. Moreover, this is the earliest age for receiving regular Social Security benefits, but the benefit will be permanently reduced.

Ages 62–64. The earnings threshold for those still working and collecting Social Security benefits is $12,000 in 2005 (indexed for inflation in future years). There is a $1 loss (a "give-back") in benefits for every $2 earned above that amount. In addition, a portion of benefits may be taxed as income (based on a complex formula that includes wages and tax-exempt income).

Age 65. Most company pension plans provide full benefits. Medicare eligibility generally begins at this age. Moreover, those born in 1937 and earlier are eligible for full Social Security benefits. However, "full retirement age" for younger workers to receive full Social Security benefits is slowly rising and will affect those born in 1938 and later. For example, full retirement age for those born between 1938 and 1959 rises incrementally until, for those born in 1960 and later, the age for receiving full benefits is 67. Those still working will be able to receive full Social Security benefits regardless of earnings, although some beneficiaries may find a portion of benefits may still be taxed based on a formula that includes wages and tax-exempt income.

Ages 65-67. The lower earnings threshold amount noted above still applies for years prior to full retirement age, and a second earnings threshold rule applies for the year in which full retirement age is attained. For those still working and receiving Social Security benefits, there is a benefit loss in 2005 of $1 for every $3 over $31,800 earned for months prior to attainment. The earnings threshold no longer applies once full retirement age is attained. A portion of benefits may be taxed as income (based on a complex formula that includes wages and tax-exempt income).

Age 70½. The required minimum distributions from a traditional qualified retirement plan must generally begin by April 1st of the calendar year following the year in which you reach age 70½. (Note: Roth IRAs are not subject to the age 70½ mandatory distribution rules.)

As with all tax planning matters, be sure to consult with a qualified tax professional to help ensure your plans are consistent with your goals and objectives. $

As you manage your taxes, with both the near and distant future in mind, one important, constant goal will be to reduce your taxable income, which equals your gross income (salary, investment earnings, etc.) less your allowable deductions and exemptions. Maximizing your deductions and exemptions, as well as taking advantage of any tax credits available to you, is a great way to start thinking about saving money on your next tax bill.

Credits vs. Deductions

First things first: How is a tax credit different from a tax deduction? A tax credit reduces your tax, dollar for dollar—that is, a $1,000 tax credit actually saves you $1,000 in taxes. By comparison, a tax deduction reduces your taxable income, but is only worth the percentage equal to your marginal tax bracket. For instance, if you are in the 25% marginal tax bracket, a $1,000 deduction saves you $250 in tax (.25 x $1,000), which is $750 less than the savings with a $1,000 tax credit. The higher your tax bracket, the more a deduction is worth, but a credit is always worth more than a dollar equivalent deduction.

Tax credits reduce your tax bill, but in many instances certain restrictions, such as income limits, apply. If you have dependent children, you may be eligible to claim a $1,000 child credit (for 2005) for each child under the age of 17. Other family-related credits include the adoption credit, and the dependent care tax credit. If you are funding a child's education, or your own, you may be eligible for the Hope Scholarship Credit and/or the Lifetime Learning Credit. The Hope Scholarship Credit provides a $1,500 tax credit for college education expenses during a student's first two years. The Lifetime Learning Credit, which applies to both undergraduate and graduate education costs, covers 20% of the first $10,000 in expenses.

All taxpayers may either claim a standard deduction or itemize deductions for personal expenses such as charitable contributions or home mortgage interest. Income limits apply to taxpayers who itemize deductions. In general, a taxpayer claims an itemized deduction when the total of qualified deductible expenses exceeds the standard deduction, or if the taxpayer does not qualify for the standard deduction. For tax year 2005, the standard deduction for single filers equals $5,000 ($10,000 for joint filers).

How is a deduction different from an exemption? Personal and dependent exemptions are reductions in adjusted gross income in addition to the standard deduction or itemized deductions. Every taxpayer may claim a personal exemption for him or herself, unless being claimed as a dependent on another taxpayer's return. A married couple filing a joint return can claim two personal exemptions, one for each spouse. Even if one spouse has no income, that spouse is not considered the "dependent" of the other spouse for tax purposes. Exemptions will decrease for high-income taxpayers with AGIs above a certain phase-out threshold.

Above-the-Line Deductions

Retaining as much of your gross income as possible should be an ongoing objective, not something that happens only at tax time. Above-the-line deductions, if you qualify, reduce your adjusted gross income. They are so named because they are taken on your tax form just above the line where you enter your AGI. Possible deductions include: contributions to qualified retirement accounts; higher education expenses; student loan interest; alimony; early withdrawal penalties; moving expenses; or part of the cost of a new, environment-friendly hybrid vehicle.

Long-Term Capital Gains and Dividend Reform

As an investor, planning your tax strategy ahead of time can have a significant impact on your tax liabilities, particularly since the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) offers significant long-term capital gains and dividend tax relief through 2008. For investors in the top four income tax brackets, the long-term capital gains rate has been reduced from 20% to 15%. Qualified corporate dividends will also be taxed at 15% instead of the investor's marginal rate, which prior to JGTRRA could have been as high as 38.6%.

For investors in the 10% and 15% brackets, a 5% tax rate applies to long-term capital gains and qualified dividends through 2007, and a 0% rate will apply in 2008. These JGTRRA provisions will expire in 2009, when prior law will again take effect. For planning purposes, it is important to note that JGTRRA makes no changes to the taxation of short-term capital gains, which will continue to be taxed at the investor's marginal rate.

To prepare an effective tax solution, advance planning is key. After all, April 15th is never too far away, and the sooner you begin planning, the greater your savings opportunities. Talk to your tax professional to create strategies that are right for your situation. $