One way to better control your estate is to give it away while you are alive. You have control over its distribution, and you get to enjoy the emotional reward of helping others. Of course, you must balance gifting with your own needs. It would be unfortunate to give away your estate and then require help living out your last years.
By bestowing gifts, you also enjoy the benefit of possibly eliminating the need for probate. Gifted assets stay out of probate, which isn't triggered until after death. You don't necessarily escape taxes on those gifts, though.
Large gifts are added to your taxable estate to determine your "gift and estate tax" bill when you die, from which the unified credit is subtracted. The unified descriptor is used for the tax credit because it is to abe applied to the combination of large lifetime gifts and your eventual estate.
As of 2006, you and your spouse can each give up to $12,000 to an individual in one year without incurring any gift tax. Any gift exceeding $12,000 becomes a large gift, and as a result is subject to gift tax.
However, you don't have to pay a gift tax unless the cumulative total of all large gifts you have ever made exceeds $1,000,000 (the maximum amount of the unified tax credit you use up on gifts during your lifetime reduces dollar for dollar the credit you can apply toward your estate. So if you can keep your gifts below $12,000, you will be able to eventually save on your estate taxes.
Gift property does not avoid taxes forever. When giving away appreciated property, the person you give it to will take over your cost basis. She eventually will have to pay income taxes on it when she sells it. The good news is that the gain is figured from what you originally paid for the asset, not the value at the time you gifted it.
On the other hand, if you pass it to people through inheritance, their cost basis is the value of the asset at your death. For example, let's say that you have a thousand shares of a $100 market-value stock that you bought for $25.
If you give it to your daughter during your lifetime, eventually she will have to pay taxes on the $75-per-share appreciation in value. If you give it to her through your estate, her cost basis becomes $100, and she will only have to pay taxes ont he appreciation above that level. Of course, your estate will pay taxes ont he $75-per-share appreciation, so collectively, either way you do it you and your daughter are eventually paying taxes on the full appreciation.
The difference is in the tax rates used and the exemptions available. If you are under the unified credit amount, you will pay no estate taxes on that stock. If not, then your estate will be paying at a 45 percent rate.
Capital gains taxes for you daughter currently don't exceed 15 percent, so if you are going to be over the unified credit, a gift saves you 30 percent (the 45 percent estate tax rate minus the 15 percent capital gains rate) of the asset's value. Plus, it's deferred until she actually sells it.
It is important to remember that in order for your handing over of an asset to be a true gift, you must relinquish all rights to it. You can't give away shares of stock but continue to receive the dividends or remain custodian of the account. If you do, you legally still own it.
An excerpt from the book, A Million Is Not Enough by Michael K. Farr.