The Retirement Corporation of America

How To Cope With Estate Taxes

THERE IS SUPPOSED to be a noble purpose behind the estate tax—to share the wealth among everyone by keeping a few families from piling up more and more wealth.

The more wealth, the more it was taxed at death—putting more back into the pot for everyone to share.

Noble as that idea was, it raised a couple of very big issues:

•  The fairness issue: All the wealth that you have accumulated over your life has been taxed already, or is subject to taxation. If you own assets in taxable accounts, you purchased them with dollars that had already been taxed once. If you own assets in tax-favored retirement accounts, you are committed to pay taxes when the assets are withdrawn. So, the estate tax amounts to double taxation. And, in the interest of fairness, no one should pay taxes twice on the same asset.

•  The dollars and cents issue: All it took to trigger an estate tax in 2001, before the new law was passed, was an estate of $675,000. That may sound like a lot of money if you are still fairly young and haven't built up much in the way of wealth. But when you total up the value of your home, all your retirement accounts, any other investments, and the insurance on your life, $675,000 doesn't sound like such an exalted figure anymore. If you piled up a net worth of $1 million, you stood right in the line of fire when it came to estate taxes, before the 2001 law was passed.

So the 2001 tax law began phasing out the estate tax year by year, as well as cutting the rate at which estates are taxed. By 2010, the estate tax is supposed to be long gone—a bit of ancient history. Still, it took a lot of political jockeying to get that 2001 law through Congress. There was great concern that repealing the death tax might do great damage to the federal budget in the years ahead.

So Congress phased out the estate tax over time, and repealed it outright for 2010—to be restored in 2011.

This ranks as one of the most questionable ideas Congress has ever come up with. If you die in 2010, you can leave an estate of $1 billion to your kids—absolutely free of estate taxes. If you die in 2011, all but $1 million of that $1 billion estate will be taxable. As critics who took it to the extreme saw it, children all over America might "do away with" their parents in 2010 in order to escape the estate tax, which would return in 2011.

Something will have to give between now and 2011. Either Congress will extend the estate tax repeal or it will restore the tax but only after a very high threshold has been set. However, since no one knows what Congress will do about this mess, or when, you need to be prepared. You need to have an estate plan that takes into account the 2001 tax law and how it changes the estate tax. That's why, far from simplifying estate planning, the 2001 tax law simply makes it far more complicated. You can't ignore estate planning. Instead, you just have to work harder at it.

How the 2001 Tax Law Changed the Estate Tax

Getting Out From Under the Tax

So you may escape estate taxation completely but, then again, you may not. It all depends on what Congress does in the years to come. It also depends on how much wealth you accumulate over the years.

The aim of heavy-duty estate planning is to keep you from having to pay any estate tax by keeping the estate below the level at which the estate tax kicks in. Under present law, you could build up an estate of $2 million in 2006 and not owe any estate tax. By 2009, your estate could reach $3 1/2 million before you owed any estate tax.

The strategy is pretty obvious: Make sure you don't leave an estate big enoughso it will be taxed. And how do you do that? Remove enough assets fromyour estate before you die. And how do you remove assets from your estate?

Technique #1: Give your assets away to other people. If you give part of your estate away in the form of gifts, you can bring joy to other people and reduce the threat that your estate will be taxed at your death. We'll go more deeply into giving away assets below. For now, just understand that giving away assets is one feature of estate planning.

Technique #2: Put your assets into trusts. If the asset is owned by a trust, rather than by you, there is a very good chance it will escape estate taxation. Trusts are also very useful in directing assets to the people you want to hold them. We'll also go more deeply into trusts later in this lesson. For now, just understand that putting your assets in trusts is another feature of estate planning.

Using either gifts or trusts in estate planning can be complicated. You wouldn't want to tackle either based solely on what you have learned in this lesson. You would want to work very closely with a skilled estate lawyer. In fact, the whole field of estate planning is so complicated there isn't very much of it you will want to tackle on your own. You should be prepared to take each step of the way hand in hand with an attorney who is well-versed in estate planning.

The Special Rules for Husband and Wife

There is one instance where the estate tax rules don't apply at all: assets in an estate left from one spouse to another. You could build up an estate of $1 billion, for instance. At your death, if you choose to do it that way, every penny would pass to your surviving spouse absolutely free from estate taxation.

That being the case, why should you worry about estate planning at all? Just stipulate in your will that, at your death, your entire estate passes to your spouse. He or she gets every penny of your estate and Uncle Sam doesn't collect a penny.

The answer is that someday your spouse will die as well. Your spouse's estate will include all the wealth he or she inherited from you, plus whatever additional wealth has been accumulated in the years since you died. And since there is no surviving spouse to inherit tax free, all that wealth is definitely subject to the estate tax.

You spared your spouse an estate tax headache at your death. But you have inflicted a double tax headache on your heirs when your surviving spouse dies. They must pay whatever estate tax is due on the combined estates—what was in your estate and what is in your spouse's estate.

Furthermore, if you do owe estate taxes, there isn't a lot of "wiggle" room. You must settle up quickly, collecting assets from wherever they may be found. You might have to sell securities in a falling market. You might have to sell the family home, or the family business.

Intelligent estate planning makes use of the marital deduction, but it isn't based 100 percent on the marital deduction. It's also based on gifts, trusts, and other techniques that reduce the estate to levels that don't "draw" the estate tax.

Congress may make all this planning unnecessary by voting to repeal the estate tax once and for all, instead of restoring it in full force in 2011. But you can't make financial plans based on what might happen. Make your estate plans. If they become unnecessary, all you have lost is some time and money.