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. 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.
2013 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 for 2013 is expected
to be $5.25 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 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.
Read more about the future of the Estate Tax >
Last Revised 1/6/2013