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This article was updated on June 8, 2016

The estate and gift tax only applies to individuals whose assets are worth more than $5.45 million, but there are ways to reduce or eliminate the tax even if your estate exceeds this threshold. One of the most valuable ways of avoiding estate taxes is the annual gift exclusion, which can help you pass your money to your heirs tax-free over time. Here's what you need to know about how the gift tax exclusion works, and how to make it work for you.

How estate and gift taxes work
Estate taxes are assessed for the "privilege" of leaving your money and property to heirs after you die. At first glance, the estate tax structure may seem a bit complicated, with 12 different brackets ranging from 18% to 40%. However, it is simpler than it appears.

For the 2016 tax year, the IRS provides a tax credit that makes the first $5.45 million of any estate tax-free, which is known as the lifetime exemption. This amount includes money and property, as well as any taxable gifts you give while you're alive. The highest estate tax bracket applies to estates valued at $1 million or above, so the effect of this exemption is that any taxable portion of an estate is taxed at the highest 40% rate. So, if you leave a $10 million estate, $4.55 million will be taxable, which translates to an estate tax of $1.82 million.

Additionally, many states have an estate or inheritance tax that can take an additional bite out of the assets you leave behind. Some of these states use the standard federal lifetime exemption amount, while others use much lower figures. For example, in Oregon only the first $1 million is excluded from estate taxes, and the state's top rate is 16% (in addition to the Federal taxes you may have to pay).

It's also worth noting that for married couples, both individuals have their own lifetime exemption. In other words, a married couple can leave a total of $10.9 million that will be exempt from federal estate and gift taxes.

The gift tax exclusion
Because of the potential for millions of dollars in taxes, estate planning is an important thing to do for high-net-worth families. One smart way to reduce or eliminate estate taxes is with the annual gift tax exclusion.

Thanks to the annual gift tax exclusion, you can give a $14,000 gift each year per person that won't count toward the lifetime exemption. In other words, you can give away as much of your money as you want, tax-free, as long as you don't give more than $14,000 to any one person during the year. If you have say, 50 relatives and friends you'd like to give a share of your estate to, this translates to $700,000 you can give away every year that the IRS won't touch. Plus, if you're married, you and your spouse can both give a $14,000 gift to each recipient, doubling the exclusion.

If you give a gift that's larger than $14,000, only the excess will count toward the lifetime exemption. You'll be required to fill out IRS form 709 to report the gift, but no taxes will be due. Rather, the taxable amount of your gift will be added to the value of your taxable estate after your death.

Over time, this can save your heirs lots of money
As an example, let's say that you are 70 years old and have an estate worth $7 million. There is absolutely no way to know the changes that will be made to the estate tax during the coming years, but based on the current exemption, $1.55 million of your estate would be considered taxable if it was passed on to your heirs tomorrow.

To combat this, you can use the annual gift tax exclusion to start giving your money away now. If you have, say, three children (all of whom are married) and six grandchildren, that's a total of twelve people -- including spouses -- that you can give $14,000 each year, tax-free. That's a total of $168,000 each year, or $1.68 million over the course of a decade, that the IRS can't touch and won't count toward your lifetime exclusion.

In the above example, this individual would have reduced the value of his or her estate to the point where it was less than the lifetime exemption. If you have a larger family, or include nieces, nephews, and other relatives, it's easy to see how this can add up even quicker.

Only time will tell
I mentioned earlier that nobody knows what will happen to the estate tax in the future, and that's especially true in 2016 since its an election year. The presidential candidates have widely varying plans for the estate tax -- presumptive Republican nominee Donald Trump wants to get rid of the estate tax all together while presumptive Democratic nominee Hillary Clinton wants to lower the lifetime exemption to $3.5 million and increase the top estate tax rate to 45%. 

The point is that the best thing you can do is to plan for the future based on what we know now, but that you should be ready and willing to change your plans over time. After all, if the estate tax is increased, gifting money now will still give you an advantage. And, if the estate tax is repealed altogether, well, I'm sure your loved ones will still appreciate your gifts.

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