Suppose you own a home, have life insurance, own a business or have a substantial retirement account with your employer. Without knowing it, you may need a lawyer. It’s not because you are on the verge of being sued, rather it’s because your net worth may be more than you realize and your family may be faced with paying hefty estate taxes.
Let’s consider an example. Say our married couple owns a home worth $800,000, has life insurance with a death benefit of $1.5 million, has another $500,000 in a retirement plan, a business worth $700,000 and general investments totaling $900,000.
If the husband in our example dies and leaves everything to his wife, there will be no federal estate tax. This is the case regardless of the amount because the federal estate tax law allows an unlimited amount of property and money to pass to a spouse free of estate tax. Assume now that our surviving wife has inherited the $4.4 million-dollar estate and lives off of the earnings for the rest of her life.
When our surviving spouse dies, her will leaves the entire estate to her children. In 2009, the children would not have been taxed on the first $3.5 million worth of property they inherited from their mother because the federal law granted each of us a credit that shielded this amount from federal estate tax. This $3.5 million exemption applied to those who died in 2009. (See the updates below–the 2017 exemption amount is $5.49 million). The children would have, however, paid federal estate taxes on the amount in excess of $3.5 million, or in our example $900,000. The tax rate in 2009 was 45% percent, which meant that the children would have paid roughly $405,000 in federal estate taxes.
The solution to this dilemma is to do a little planning before the first spouse passes away. That is, instead of leaving his entire estate to his wife, the husband in our example could have changed his will so that an amount up to the first $3.5 million of his estate would have passed into a trust for the benefit of his wife. The trust could say that all of the earnings on the trust fund would be paid to his wife. In addition, any portion of the trust could be used if needed to provide for his wife’s health and support. Upon his wife’s death, the balance of the trust would be paid to the children. In estate planning lingo, such trusts are known as “Bypass Trusts” or “Credit Shelter Trusts” and they can be created as part of a so-called living trust or established as part of your will. The exact terms of such a trust can vary. However, the key is that a trust like the one described will not be included in the surviving wife’s federal estate when she later dies. As such, when our husband dies, the first $3.5 million that is left in trust escapes federal estate taxes because it is below his $3.5 million credit. The remainder of the estate would pass to the surviving spouse and escapes federal estate taxes because of the rule that permits an unlimited amount of property to pass to a spouse free of federal estate taxes.
The most important aspect of this plan kicks in when the surviving spouse dies. At that point, any assets in the “Bypass Trust” created by her husband are not included in her federal estate. Therefore, as long as the assets she owns in her own name are valued at less than $3.5 million, there would be no federal estate tax upon her death. As such, each spouse’s estate escapes federal estate tax and our couple passes an extra $405,000 to their children.
The upshot of all of this is that if both spouses make full use of their $3.5 million credits, they can pass $7 million of property to their children without federal estate tax. With estates of this size, the savings can amount to more than $1.5 million.
2010 UPDATE: By virtue of the Economic Growth and Tax Relief Reconciliation Act of 2001 signed into law by President Bush on June 7, 2001, the federal estate tax has been eliminated for estates of those dying in the year 2010. However, the current law has a “sunset” provision that reinstates the tax in 2011 with a $1 million exemption and a maximum tax rate of 55%. Some advisors believe that Congress will take action to reinstate the federal estate tax at 2009 levels retroactive to January 1, 2010, but the future of the federal estate tax is certainly uncertain. Stay tuned.
2013-2016 UPDATE: On January 2, 2013, President Obama signed the American Taxpayer Relief Act which averted the so-called “fiscal cliff.” One part of this new act made the 2010 estate, gift and generation skipping changes permanent. This means that the federal estate tax exemption remains at $5 million per person. This amount will be adjusted for inflation each year. Based on this inflation adjustment, the exemption has increased as follows: 2013 was $5.25 million; 2014 was $5.34 million; 2015 was $5.43 million; 2016 was $5.45 million and for those dying in 2017 the exemption is $5.49 million. If your estate exceeds this threshold, the tax rate on the value of your estate in excess of the threshold is increased from 35% under the 2010 act to 40% under the 2013 American Taxpayer Relief Act.
The new law also includes a provision referred to as “spousal portability.” Subject to certain requirements, this allows a surviving spouse to claim the unused estate tax exemption of a deceased spouse. As such, it is no longer necessary to use the “Bypass Trust” described above in order to use the estate tax exemptions of both spouses.
2017 UPDATE: President-Elect Trump has pledged to repeal the federal estate tax. If the tax is repealed, it will become even more important to review “old” estate plans.
The important message is that those who made an estate plan based on the federal estate tax law as it existed prior to 2010 should have those plans reviewed immediately as they may not have anticipated the changes that have occurred and the plan they have in place may yield unanticipated results. And those with estates in excess of the $5.49 million exemption still need to plan to avoid a 40% tax on the excess.