(MONEY Magazine) – Few financial dreams are as cherished as the one of leaving something "to the kids"--not to mention the grandkids. But a desire to enrich your progeny after you're gone may obscure an important fact: If you're on track to amass a sizable estate, you can leave more to your loved ones--and less to the tax man--by giving away some of your assets while you're alive. Consider: If your taxable estate is worth $2 million when you go to the great beyond sometime well into the next millennium, Uncle Sam will extract $435,000, and let your heirs keep the rest--$1.565 million. If, on the other hand, you make 10 annual gifts of $5,000 apiece to each of your 10 grandchildren, thus whittling your estate to $1.5 million by the time you die, the estate tax will total just $210,000--and your heirs will have pocketed $1.79 million of your largesse.

To achieve such savings, however, you can't take a scattershot approach to gift giving. Instead, gifts should be part of a thorough estate plan that you create with the help of an experienced estate-planning attorney and that you update periodically as your circumstances evolve.

Two more cautions: Don't give away assets you may need later on. And don't try to get away with making a gift but retaining some control over it. You can easily run afoul of the tax law if, for example, you give stock to your daughter but continue to pocket the dividends. Our point: If you can truly afford it, generosity pays. If you want to give but have some misgivings about parting with your wealth, experts recommend making gifts on a regular schedule over a long period of time. That way, "You get to see the benefits without feeling like you're impoverishing yourself," says Michael Kutzin, an estate-planning attorney at Cassin Cassin & Joseph in New York City.

To reap the financial rewards of giving, you first have to grasp the basics of federal gift and estate taxes, known collectively as transfer taxes.

For starters, gift and estate taxes are essentially one and the same: Gift tax is levied on the giver for gifts made while he or she is alive; estate tax is imposed on property you transfer at death. The tax rates range from 37% to a backbending 55% on multimillion-dollar gifts and estates. In a rare instance of generosity, however, the transfer-tax law lets you make gifts during your lifetime totaling as much as $625,000 before you actually have to pay the gift tax. Or, if you don't make any taxable lifetime gifts, you can die with an estate valued up to $625,000 before owing estate tax. (The $625,000 exemption amount is scheduled to rise to $1 million by 2006, but for simplicity's sake, we have assumed a $625,000 exemption in the examples that follow.)

If you think that transfer taxes are a concern only for the millionaire next door, think again: Your estate includes not only such obvious assets as your house, your investments and your personal belongings but also the death-benefit payout from your life insurance policy, the sums in your retirement savings plans, and your share of jointly owned assets. "Very often, middle-class people are surprised to find out how much they'll be worth when they're gone," says Howard Zaritsky, an estate-planning attorney in Fairfax, Va.

That said, the tax law gives you more leeway to avoid gift tax on lifetime transfers than to sidestep estate tax after you die. Here's how to use gifts to keep your wealth from being eroded by taxes as it shifts from generation to generation.

TAX-FREE GIFTS

With any gift, you pare the size of your estate, thus reducing or eliminating eventual estate tax. But certain gifts let you accomplish this without ever incurring a gift tax. For example, you can pay someone else's college tuition or medical bills gift-tax-free, as long as you pay the educational or medical institution directly.

Moreover, thanks to a freebie in the tax code called the gift-tax exclusion, you can make tax-free gifts of as much as $10,000 a year--$20,000 if you give jointly with your spouse--to each of as many people as you wish. (Starting in 1999, the exclusion amounts will be indexed for inflation.) Above those limits, a gift is taxable, and you must report it to the Internal Revenue Service when you file your income tax return, using Form 709. But even then, you won't have to pay the gift tax right away. Rather, the taxable amount of a gift is merely subtracted from the $625,000 transfer-tax exemption. If you give your niece $30,000 this year, for example, the taxable portion of the gift comes to $20,000 ($30,000 minus your $10,000 gift-tax exclusion). Assuming you haven't made any other taxable gifts, your allowable exemption will drop to $605,000 ($625,000 minus $20,000).

TAXABLE GIFTS

Once your good-heartedness exceeds the $625,000 exemption threshold, you must fork over the gift tax on any subsequent taxable handout in the year after you make the gift. Surprisingly, however, you'll continue to pile up tax savings by making gifts even after you've used up your exemption. Take this example from Peter Nussbaum, a certified public accountant who specializes in estate planning at M.R. Weiser in New York City: If a widow bequeaths her $3 million estate to her son, the federal estate tax would come to $1.089 million, leaving him $1.911 million after taxes. In contrast, if she makes a lifetime gift of $1 million, she'll owe $144,000 in gift tax--but she'll reduce her estate to $1.856 million (that's $3 million minus the amount of the gift and the tax payment). When she dies, the tax on her estate would come to $868,000, for an after-tax bequest of $988,000. Still, the amount that reaches her son would total $1.988 million (the $1 million gift plus the $988,000 net estate). That's $77,000 more than if she held on to the full $3 million until her death.

Warning: Big-ticket gift giving won't work if you do it on your deathbed. The reason: If you die within three years of making the gift, the gift-tax payment will be added back to your estate.

WHAT TO GIVE

The ideal asset to give away is one with a current low value but great growth potential, such as recently purchased value stock or undeveloped real estate. For example, if you and your spouse make a $20,000 tax-free gift of stock that grows in a decade to $60,000, you've also removed the $40,000 in appreciation from your estate, transfer-tax-free.

Another tip: A life insurance policy is also a great asset to give away because its value for gift-tax purposes is roughly equal to its cash value, which is generally far less than the death benefit that will be paid out--and added to your estate--when you die. To make the gift, you can simply fill out a form from the insurer transferring the ownership of the policy to whomever you choose. But many estate-planning attorneys recommend that you transfer ownership to an irrevocable life insurance trust with your heirs as its beneficiaries. That way, you have a hand in setting the trust's terms, such as when payouts should be made. Don't dawdle if you have a big insurance policy to unload, however. If you die within three years of giving away your policy, the entire death-benefit payout will be included in your estate.

You can also cede shares in a family business to your children through a family limited partnership or a limited- liability company. These arrangements allow you to control your business, while giving your kids ownership interests. With a family limited partnership, for example, you set yourself up as a general partner with your kids as limited partners. Because the kids don't control the business, the value of their shares is discounted. Say you make your two kids limited partners and give them 50% of a $4 million business over several years. A professional appraiser might estimate that the kids' shares are worth $1.5 million--a $500,000 discount on which you completely avoid transfer tax. Better still, if your business grows to perhaps $6 million by the time you die, only your 50% ownership share, or $3 million, is included in your estate.

Once you identify the assets that yield the best tax result when given away, let your estate-planning attorney advise you on how to make the transfers. After all, you can't take it with you. So what's the use of owning it when you die?