Could You Please Die Sometime in 2010?
And other frequently asked questions under today's crazy estate-tax law
(MONEY Magazine) – Death and taxes are supposed to be life's only certainties, but the so-called death tax is about as certain as next year's weather. "The 2001 Tax Reform Act took a complex system and made it unpredictable as well," says Helen Modly, a financial planner with Focus Wealth Management in Middleburg, Va. "There are still great opportunities to pass on wealth without taxation, but it can take some serious juggling."
If you don't particularly want to fool with estate planning anyway (as if anyone does), you may find the current mess a perfect excuse to procrastinate. A word of advice: Don't. You might throw away tax breaks worth hundreds of thousands of dollars. "I see people with significant assets who are waiting for the dust to settle before they plan," says Modly. "They may be dust before that happens."
The biggest unknowns: What portion of your assets will be exempt from federal estate tax when you die, and what rate will you pay on the rest? The answers vary, to put it mildly, depending upon when you kick the bucket. Between now and 2011, the amount you can leave tax-free when you die, known as the estate-tax exemption, will range from $1 million to infinity. (See the top box on page 44B for details.)
The top estate-tax rate, meanwhile, bounces around between 45% and 55%, with a brief stop at zero. And lawmakers are likely to come up with yet more changes--though what such changes will look like is anyone's guess, given polarized politics and soaring federal deficits. (Note to Congress: Uncertainty over estate-tax rules is not helping your awful approval ratings.)
Still, the estate-planning profession has had four years to come up with ideas for winning a contest whose rules keep changing, and they've made some progress. Let the serious juggling begin. STRATEGY NO. 1 Die in 2010 That's when the estate tax disappears altogether--but only for a year. Your heirs will pay absolutely nothing if you die during that 12-month window! What's that you say? Okay, let's move on...
STRATEGY NO. 2 Assume That You (Yes, You) Will Be Subject to Estate Tax The amount you can leave tax-free to heirs stands at $2 million now and will hit $3.5 million in 2009. That solves the estate-tax problem for most folks, but only temporarily. The estate-tax exemption reverts to $1 million in 2011. Although even that may sound like a lot of money, many Americans are unknowing millionaires (or will be) if you count the value of their retirement savings, life insurance and real estate.
A mere $200,000 in retirement savings at age 45 will, assuming modest 5% returns and $500 a month of additional savings, grow to about $750,000 by the time you're 65. Sure, you'll spend some of that in retirement, but throw in the proceeds from a company life insurance policy and a three-bedroom house in the suburbs and, congratulations, you've got an estate-tax problem to solve.
STRATEGY NO. 3 Double Your Tax Break The unlimited marital deduction lets you leave as much as you like to your spouse tax-free. Unfortunately, there's a huge catch. When you leave money directly to your spouse, you increase the chance that the value of her estate will exceed the amount she can leave tax-free to your children or other heirs.
Until the 2001 law took effect, estate planners solved the problem by having each spouse earmark up to $675,000 for a bypass trust. (The $675,000 was equal to the old estate-tax exemption.)
Here's how the strategy worked. (Now stay with me; there's a lot of money at stake.) Let's say Dad died first (he usually does). Mom could've drawn on the trust income, but the trust principal went to the kids when Mom died.
The beautiful part is that the kids paid no tax on the money in the trust. Reason: Mom never got her hands on that dough, so it was still protected by Dad's $675,000 estate-tax exemption.
What's more, Mom could've used her own $675,000 exemption to shelter money outside the trust. Bottom line: The kids could inherit a total of $1,350,000 tax-free from their parents.
What if Dad had skipped the trust and simply left his assets to Mom? The kids could end up paying tax on any amount over Mom's $675,000 exemption when she died. Bummer, Dad.
The bypass-trust strategy still works--with a twist. The general idea is the same: Fund the bypass trust with an amount equal to your full estate-tax exemption. Trouble is, the $%^#@#! exemption keeps changing. One solution is to create a will that funds the trust with an unstated amount equal to whatever the exemption is at the time of your death (or as close to it as your estate can afford).
And get this: The kids don't have to pay taxes on the growth of the assets while they're in the trust either. "That can be a very big deal, especially if you fund the trust with growth-oriented assets like stocks or real estate," notes Susan Thomas, an estate-planning attorney with Murray Plumb & Murray in Portland, Maine.
STRATEGY NO. 4 Tell the Kids to Just Say No The more unstable the rules, the more flexibility your heirs need, which explains the growing popularity of an estate-planning tool known as a disclaimer. A disclaimer allows your heirs to pretend that they died before you did, so that the asset passes to the next-in-line beneficiary. For example, your surviving spouse can disclaim an amount up to your estate-tax exclusion. That leaves the money to pass directly to your children without any tax.
Alternatively, children who are already well off might use disclaimers to refuse some assets inherited from you. That allows the money to pass directly to their children, assuming your will puts those grandchildren next in line. The assets skip the middle generation, thus avoiding any tax upon their death. Take note: This strategy works only for amounts totaling less than the generation-skipping exemption ($2 million this year, rising to $3.5 million in 2009).
Disclaimers can be a great way to transfer IRA assets to children (or grandchildren), significantly extending the tax benefits of the account. For example, the surviving spouse can disclaim the IRA, which can then go to the child. The child can take distributions over his or her lifetime, allowing the money to compound tax-deferred for another generation. "Stretching out distributions from an IRA can make a huge difference in a family's ability to build wealth over time," says Ed Slott, an IRA specialist in Rockville Centre, N.Y.
Disclaimers and flexible-trust documents give your executor significant power to manage your estate, for better or worse. He or she should be prepared to work closely with your estate planner to avoid mistakes that could derail your plan, such as dipping into an account earmarked for a disclaimer. (Heirs may not be able to disclaim some assets once you've drawn on them.)
"My husband is a financial adviser too, but I tell him to call the estate planner before he orders flowers for my funeral," says planner Modly. "And that's not just rhetoric: If he pays for them with the wrong account, those flowers could be extremely expensive."
• Estate taxes go down, then up, through 2011. After that, who knows?