“What can I do to save my family from taxes when I die?”  This is a question that I often hear from clients, and the answer is different based upon the marital status of the client.

If a married couple is asking the question, there is a way in which their last wills and testaments can be drafted that will save the couple a significant amount of estate tax.  If a single person is asking the question, gifting may be the only viable answer.

Currently, a New Jersey resident faces two distinct estate taxes—federal estate tax and New Jersey estate tax.  While the New Jersey estate tax is based upon the federal estate law as the law existed in 2001, the two taxes have nothing to do with one another, and an estate may have to pay both taxes, if the estate is valuable enough.

New Jersey estate tax is imposed if the gross value of the estate exceeds $675,000.  The gross estate includes all assets that the individual dies owning including the death benefit of life insurance.  The federal estate tax is imposed if the gross value of the estate exceeds $5,000,000, though that may change in 2013.

Because the federal estate tax credit equivalent (that is, the $5,000,000) is so high, most of the clients I meet have New Jersey estate tax issues, not federal estate tax issues.  Though, as mentioned, an estate could pay both federal and New Jersey estate tax.  For instance, if a person died with $6,000,000 in assets, his estate would have to pay federal and New Jersey estate tax.

Let’s assume that Mr. and Mrs. Smith come to see me, and they have an estate worth $1,000,000, which includes the value of their home, their brokerage accounts, IRAs, and life insurance policies.  The Smiths have a New Jersey estate tax issue.

If the Smiths have simple Wills—Wills that simply leave everything to each other then their children –a New Jersey estate tax will be imposed upon the death of the second-to-die spouse.  The New Jersey estate tax is about 10% on average, so on a $1,000,000 estate, the tax will be approximately $32,000, after the $675,000 credit is applied to the estate.  The Smiths could avoid this tax by employing a rather common tax planning technique in their Wills.

In order to eliminate this tax, the Smith would have trusts drafted into their Wills.  The problem with a married couple having simple Wills is that there is no tax between spouses, so Mr. Smith could die and leave $20,000,000 to Mrs. Smith and there would be no tax.

But, because there is no tax, the Smiths don’t use Mr. Smith’s $675,000 credit when he dies, and after he dies, his credit is lost forever.  The Smiths then have a doubling up of their estate in Mrs. Smith’s name and are left with only one $675,000 credit, Mrs. Smith’s credit.

If the Smiths have their Wills drafted so that up to $675,000 in assets passes to a trust for the second-to-die spouse, then they will use both $675,000 credits.  For instance, when Mr. Smith dies, up to $675,000 in assets passes to a trust for Mrs. Smith’s benefit.  Because those assets passed to a trust, and not directly to Mrs. Smith, the assets passing to the trust use up Mr. Smith’s $675,000 credit.  This is true even though the trust is for Mrs. Smith’s benefit and even if Mrs. Smith were the trustee of the trust assuming the trust is drafted correctly.

Now, when Mrs. Smith dies, she doesn’t die owning $1,000,000 in assets, she dies owning only $325,000 in assets, the difference between $1,000,000 and the $675,000 in assets that passed to the trust.  Since neither Mr. Smith nor Mrs. Smith die with more than $675,000 in assets, there is no tax imposed on either of their estates.  Their children now avoid the $32,000 in tax, and Mrs. Smith had the benefit of the couple’s money her entire life.

This kind of planning cannot be done with a single person.  So, if Mrs. Smith comes to me after Mr. Smith dies and assuming Mr. Smith had a simple Will that left Mrs. Smith her entire estate, my advice might be that Mrs. Smith’s only method of reducing the estate tax for her children is to make gifts.  There are all types of gifting methods, but a common, and simple, technique involves giving $13,000 a year to anyone person you wish to benefit and repeating this gift each and every year.