Estate taxes can be the proverbial thorn in a beneficiary's side. Usually, these taxes are paid on the property left to an heir when someone dies. If you make a gift of money or assets while you're alive, you may trigger federal and state gift taxes, too.

Before you make your will or make a gift, it's a good idea to know how your taxes might be impacted.

Federal Estate Taxes

Estate tax is a tax on your right to transfer property at your death. It covers everything you own or have certain interests in at the date of death, such as cash and securities, real estate, insurance, trusts, annuities and business interests.

Take the fair market value of your assets and add them together. This gives you your gross estate. Then you're allowed certain deductions, such as mortgages and estate administration expenses. This gives you your taxable estate - the amount used to calculate the tax.

For decedents who died in 2010 only, new rules make it possible to value estates without using the fair market value.

Your estate - not your beneficiaries or heirs - pay the estate tax.

How Much?

When the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 became law, new federal estate and gift taxes went into effect. Only estates worth more than $5 million have to pay the estate tax. The maximum amount of the tax is 35 percent on any amount over $5 million.

This covers estates of decedents who die in 2010, 2011 or 2012.

Generally, the estate tax return is due nine months after the date of death. You can get an extension if you ask for one before the due date, and you pay the estimated correct amount of tax before the due date.

Federal Gift Taxes

The gift tax is a tax on the transfer of property by you where you get nothing, or less than full value, in return. The tax applies whether you intend to make a gift or not. You make a gift if you give property (including money), or the use of or income from property, without expecting to receive something of at least equal value in return.

During your lifetime, you can make tax-free gifts to others. For 2010 and 2011, as long you gift $13,000 or less to any one recipient per year, neither you nor the recipient has to pay taxes. Generally, gifts over this amount are taxed at 35 percent; either you or the recipient must pay that tax.

Other gifts you won't be taxed on:

  • Direct payments of someone's tuition or medical expenses
  • Gifts to charitable organizations, which may be tax deductible
  • Gifts between spouses

You're also entitled to a lifetime credit against the gift tax. It's is a dollar-for-dollar reduction of any tax due. The total amount of tax-free gifts is $1 million for 2010 and $5 million for 2011 and 2012.

When giving a taxable gift, you must file a federal Gift Tax Return on Form 709. It's due by April 15 of the year after the gift is made.

GST Tax

The generation-skipping transfer (GST) tax is a tax on gifts, and transfers in trust, to anyone two or more generations younger than you, like a grandchild. You'll have to pay GST tax if you:

  • Make taxable gifts to grandchildren or others considered to be two or more generations younger than you
  • Leave property to someone two or more generations younger than you, based on your family relationship or the difference in your ages
  • Transfer property to a non-relative who's more than 37 and a half years younger than you

For 2010, you can make taxable gifts of up to $1 million to grandchildren without having to pay GST tax. For 2011 and 2012, the limit is $5 million.

State Taxes

Some states have estate and gift taxes, too. There are two types of these taxes:

  • Inheritance taxes are paid by your beneficiaries or heirs, not by your estate. Typically, how much they pay depends on their relationship to you
  • State estate taxes are similar to the federal estate tax. Your estate must pay this tax no matter who your beneficiaries are

You Say Who Pays

You can say who has to pay estate or inheritance taxes in your estate plan. A tax apportionment clause in your will lets you determine how taxes are paid. Be sure to consider all types of taxes your estate or heirs may have pay and try to be fair to everyone.

Also, many states have laws requiring apportionment of estate taxes among the beneficiaries unless the will directs otherwise.

Just the Surface

We've only scratched the surface of estate and gift taxes. There's much more you may need to think about, depending on the size of your estate and other personal circumstances. To save the most money possible, it's a good idea to talk to a tax lawyer with experience in the federal and state estate and gift tax laws and come up with a plan.

Questions for Your Attorney

  • If someone dies in 2011, how much of his estate passes to his beneficiaries without federal estate taxes being due?
  • How much in gifts over $13,000 can I give away during my lifetime without incurring a gift tax?
  • How did reforms in the federal estate tax impact the state inheritance and gift tax scheme in my state?