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How It Works: Estate Tax and Calculating Your Estate Tax Burden

In our earlier post, we talked about why some DIY wills (i.e. Do-it-Yourself) might pose problems, particularly if one doesn't understand estate taxation.

The thing is that many people assume that estate tax is for the rich. What many don't understand is that estate tax is one of those areas of law that fluctuates and that it's very possible that the amount of estate tax exemption in a year of one's death could be lower than anticipated.

Additionally, many people think that if they get an asset out of their probated estate, it won't be taxed. So they create revocable living trusts, thinking that the assets in that trust won't be taxed. That's simply not true.

Translation: If you've got assets that total around the million dollar mark, you might want to think about proper tax planning .

Tax concepts are hard to understand and the taxation of wealth transfer (i.e. estate planning) is one of the most complex areas of taxation, with issues like the Generation Skipping Transfer Tax, the Gift Tax and others.

So we thought we'd bring you a primer on the tax issues affecting wealth transfer -- at least the federal tax issues. We'll start this discussion off with the basics of an estate and the estate tax.

There is something called the applicable exemption. This, for the year 2012, is set at $5.12 million.

Translation: Any value over $5.12 million in a decedent's estate will be taxed, at a rate of 35 percent. But assets adding up to $5.12 million or less won't be taxed.

Now that we've discussed the amount of taxation, we need to ask the most important question: What is your estate, for estate tax purposes?

Translation: What exactly can Uncle Sam sink his teeth into?

First, let's talk about your gross estate. Your gross estate is the fair market value of everything you own on the date of your death.

This includes cash, real estate, stocks, bonds, insurance, annuities and any other assets.

Now, you take your gross estate and subtract certain things from it. There are many things you can subtract and a good estate planner is usually aware of these deductions. For example, you can subtract charitable contributions made by your estate. You can also deduct the full amount of anything given to your spouse from your gross estate, if your spouse is a U.S. citizen (that's called the marital deduction).

You're left with your taxable estate.

Now, go back throughout your life, all the way back to 1977 (assuming you were alive then). Did you make any gifts over the annual gift tax exemption amount? Take the amounts over the annual gift tax exclusion for that year and add those amounts back to your estate.

You have now reached your tax base.

Translation: The estate tax will apply to this amount.

Stay tuned for a discussion on gift tax.

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