No one would want the assets they've worked their entire life to build to be dwindled away needlessly when they die. Unfortunately, this is exactly what happens for many people, mainly because they don't create a smart estate plan.

Life Insurance and Estate Tax

Estates are taxed based on their net worth, in other words the amount you own minus the amount you owe. Contributions to qualifying charitable organizations, funeral expenses, and administrative expenses of the estate can also be deducted from your estate's net worth. While the estate tax currently only applies to estates with a net worth more than $1.5 million, once you add up the values of your home, bank accounts, IRAs and personal possessions plus the death benefit of a life insurance policy, and then consider how those assets will grow over time, many people unknowingly exceed the $1.5 million threshold, or will eventually.

The estate tax, which starts at a hefty 45 percent rate, can slice into your family's inheritance. A straightforward will alone could result in huge tax liabilities. While you are allowed to leave an unlimited amount to your surviving spouse, your estate will eventually be fully taxed upon the spouse's death.

Luckily there are some effective strategies that can minimize the tax burden:

Bypass Trust

Up to $1.5 million can escape taxation through a bypass trust, also known as a credit shelter trust or exemption trust. The donor places assets into the trust, sets the rules regarding the management and distribution of money, names trustee(s) who are responsible for following those guidelines and names one or more beneficiaries.

The spouse can be named as the primary beneficiary and the children as secondary beneficiaries. The donor can dictate that the beneficiary receives both income and principal from the trust for needs related to maintenance, education, support and health. This type of trust is only for married couples and United States' citizens.

Insurance Trusts

An Irrevocable Life Insurance Trust provides an additional way to minimize estate tax and is often used in conjunction with a Bypass Trust for excess assets.

A married couple can establish and fund the trust, naming their children as both trustees and beneficiaries. The trustees use the trust fund to buy a special form of life insurance called a survivorship life policy. The policy insures the lives of the donors but is owned by the trust and the trust is the beneficiary. The value of the policy is set to equal the anticipated cost of estate taxes so that after both donors die and the estate taxes become due the trustees can pay the taxes from the insurance policy proceeds rather than the estate itself. The cost of this strategy is the insurance premium which is significantly less than the estate tax.

One catch is that if you were to die within three years of establishing the trust, the IRS would be concerned that you transferred assets in contemplation of death, and then your estate would be taxed on the value of the death benefit.

Estate Tax Demise

Currently the estate tax is scheduled to phase out by 2010. Each year until then the $1.5 million exemption limit will be increased. Don't risk your hard earned assets on the phaseout, because the estate tax could be back in 2011 with a lower $1 million limit if Congress doesn't act explicitly to extend the repeal.

Besure to seek the advice of a qualified legal and/or tax professional before final decisions are made concerning your estate planning.

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