Estate Tax: What You Need to Know for 2010

Here’s what you need to know about the estate tax, and how to protect yourself and your heirs, at least until Congress takes action.

• Both the estate tax and the generation-skipping transfer tax (on assets given to grandchildren) were repealed at the end of 2009.
• Both taxes are scheduled to return in 2011 at the unfavorable rates that applied 10 years earlier. The amount that is exempt from each of these taxes will then be $1 million, and the tax on the rest will be 55 percent.
• There is still a gift tax if you give away more than $1 million during your lifetime, but the tax rate has been reduced from 45 percent to 35 percent.
• Heirs will now have to use the original price paid for an asset when computing their tax liability, instead of the value upon the owner’s death. This change of “cost basis” could be very expensive, and difficult, for heirs. For example, if you inherit shares of Microsoft (MSFT) that your father accumulated over many years, you might be stuck hunting for all his transaction slips and adjusting for stock splits along the way (a potential nightmare). And when you sell any of the shares, you may owe capital gains tax on the appreciation. Each estate can exempt $1.3 million of gains from this carryover basis rule, as it’s called. Another $3 million exemption applies to assets inherited from a spouse.

Most estate planners expect Congress to restore the taxes retroactively, and to put back in place the system that applied in 2009: a $3.5 million exemption for estate tax and generation-skipping transfer tax, with a 45 percent rate for these two taxes as well as the gift tax.

If Congress passes retroactive legislation, past court cases suggest that restoring the tax this way is perfectly legal. But people with enough at stake may bring lawsuits arguing that a retroactive tax is unconstitutional. The sooner Congress acts, of course, the fewer the number of people with an incentive to bring such cases and the less chance they will have.

If the weeks drag into months without resolution on the tax front, these are some issues to consider (roughly in order of the number of people they affect):

What’s a Bypass Trust?
(And Why You Need to Worry About It)

Formula clauses in wills and trusts, which express inheritances in terms of fractions or percentages, may lead to problems for people who have set up trusts designed to reduce estate taxes.

Here’s how bypass trusts (often called family trusts) work: Assume your will includes a formula clause that would allocate up to the maximum tax-free amount to the trust if you die before your spouse. The trust distributes your assets as you specify in the trust document — say to your spouse and family members while your spouse is alive, and then pays what is left to family upon the death of your spouse.

Putting the funds in trust, rather than leaving them to your spouse outright, ensures that neither the assets nor any appreciation on them will be considered part of your spouse’s estate. Therefore, they are not subject to tax when he or she dies.

If the rest of your assets go to your spouse, the tax on this portion, called the marital share, is not eliminated, but rather will be postponed until that person’s death. In most cases, no tax will be assessed when you die, because assets inherited from a spouse are entitled to an unlimited marital deduction. Any money that remains of the marital share will be taxed when he or she dies.

But what happens if there is no estate tax? Depending on how a formula clause is worded, it is possible that everything will go into a bypass trust. And that could lead to some awful scenarios. One possibility, if the trust isn’t set up to make payments to your spouse (for example, if it only benefits your children from a previous marriage), is that your spouse will get nothing. Another possibility is that even if the trust does benefit your spouse, all the money will be locked up in the trust, and your spouse won’t receive anything outright.

If your estate plan now suffers from this defect, the lawyer who initially wrote the document can fix the problem with a simple amendment. Assuming these are the only changes you are making, you won’t rack up much of a legal fee.

Do you have the resources to transfer large sums of money while you are alive?

These gifts leave less for the government to tax, and if the assets increase in value after you have passed them along, the appreciation is estate-tax-free. But people in a position to do this run up against the $1 million lifetime gift tax exemption ($2 million for married couples). Most people are reluctant to make gifts so large that they will incur gift tax. For those who are comfortable with the idea, the gift tax is now 35 percent, so in theory this is a good time to make gifts. The risk, however, is that the previous tax rate, which was 10 percent higher, could be restored retroactively. So you can’t make gifts secure in the notion that the lower rate will apply. Assuming Congress reinstates the $3.5 million exemption, making taxable gifts will probably not be part of your financial planning unless you and your spouse already have at least $10 million — or expect to in the near future.

What makes $10 million the magic number? The first $3.5 million you leave behind is exempt from federal estate tax. With planning, a married couple can avoid this tax until their combined assets are more than $7 million. So yes, they would face estate tax on $3 million of their assets, but by taking advantage of the unlimited marital deduction, they can postpone that tax until the second of them dies.

Would you like to provide a financial cushion for your grandchildren in the years ahead?

Normally, when you give assets directly to grandchildren or set up a trust to do so, you need to plan for the generation-skipping transfer tax. This tax applies on top of estate tax and gift tax. With the repeal of the GST tax for one year at the start of 2010, advisers are proposing a variety of techniques to maximize gifts to grandchildren. How they will be affected by a law that takes effect retroactively remains unclear. Proceed with caution.

For all the talk right now about estate tax repeal, this tax affects very few people. In 2009 less than 1 percent of the population needed to be concerned about estate taxes. But regardless of your net worth, you still need an estate plan. And estate planning goes far beyond taxes.

Whether or not taxes were a concern for you in 2009 or might be again — either later this year or in 2011 — make a New Year’s resolution to give your estate plan a check-up, and keep it! Be sure you have all the basic estate planning documents to leave your assets to the people or charities that you wish to benefit. If you have a spouse or partner, provide for your mate financially. Name a guardian for children who are minors or have special needs and leave funds for them in good hands in case something happens to you.

Confirm that you have a durable power of attorney.

This document appoints a family member, friend or adviser as an agent to act on your behalf in financial and legal matters, and remains effective even if you become incapacitated. Without one, your family might have no choice but to ask a court to appoint a guardian to oversee your finances. This can be an expensive and embarrassing ordeal.

The best person to put in charge is a close family member — preferably one who lives nearby. Naming joint agents, which is allowed only in some states, is one way to provide checks and balances. Or you can appoint another person, such as an attorney, an accountant or a family friend, to supervise the arrangement.

Although the two are sometimes confused, a durable power of attorney, which deals only with financial matters, and a health-care proxy, which authorizes someone to make medical decisions on your behalf, are distinctly different.

Review beneficiary designation forms.

Certain types of assets do not usually pass through a will or living trust. If you have life insurance, make sure you have properly completed the beneficiary designation form, which covers who will get the proceeds. Beneficiary designation forms for your retirement accounts should also be filled out and coordinated with the rest of your estate plan. Make sure the forms include both primary and alternate beneficiaries. You should not name your estate as beneficiary — that could cause your heirs to lose important income tax benefits.

Consider converting a traditional IRA to a Roth IRA.

If you want to leave retirement assets to family or friends, this is one of the simplest, best planning tools available. You owe income tax on the amount you convert. But subject to certain restrictions, no tax is assessed when the money is withdrawn, so income can compound tax-free. You also avoid the requirement to take yearly minimum distributions starting at age 70 �, and that can leave more for beneficiaries if you don’t use the money yourself. Starting in 2010, anyone, regardless of income, can do a Roth conversion. Just be sure you have enough money in non-retirement assets to pay the tax, or you will defeat the purpose.

Watch out for state taxes.

If you’re thinking of moving to another state or dividing your time among various locations, consider the estate plan implications. About half the states have a separate estate tax, which applies not only if you live in one of these states, but also if you own real estate there. These taxes apply whether or not there is a federal estate tax.

When you change your home state, it’s important to pull up roots and establish new ones. Otherwise, if your former state has an income tax or estate tax, it may chase you, or your estate, for taxes. In a worst-case scenario, you could wind up owing taxes to two states.

All states will honor a will that’s valid in the state where it was signed, but specific terms drafted for one state could be problematic in a new one. You won’t necessarily have to redo your will if you move, but you should have a local lawyer review it, along with any other estate planning documents.

Use trusts as needed.

Trusts continue to be an important estate planning tool, but not necessarily for tax saving. For many people the focus is on other crucial purposes that trusts can serve: to hold money for minors, forestall spendthrift family members or protect assets from former spouses or creditors, for example.

Build a legacy.

There’s no need to delay thinking about the legacy you would like to leave — for example, by providing everyone in your family with the best possible education, developing a succession plan for the family business, keeping a vacation home in the family or making meaningful gifts to charity.

Above all, estate planning is a way to take care of yourself and the people you love. Whatever might be happening in Washington, no one should postpone the necessary steps. Just because Congress is inefficient and disorganized doesn’t mean that you must follow suit.