How to Get The Most Out of the Returning Estate Tax Exemption

You are probably aware that in 2010 there is no federal estate tax. It has been "repealed," but only for one year. Even though we have known this might be coming for several years, most estate planning professionals fully expected Congress to do something before 2010 arrived, even if it was only to extend the 2009 federal estate tax laws into 2010. But Congress did not act, so there is no federal estate tax this year. However, some states have their own death or inheritance tax, so while your estate may not have to pay a federal estate tax if you were to die this year, it could have to pay a state tax.

With Congress needing as many tax dollars as possible to help pay for its spending programs, the chances of permanent estate tax repeal are practically zero. We don't know when Congress will act on estate tax reform, and we do not know what the laws will be in the future. However, we do know that if Congress does nothing this year, the exemption will be $1 million in 2011 and the top tax rate will be 55%. Compared to 2009, when the exemption was $3.5 million and the tax rate was 45%, it is clear that more families will be paying more in estate taxes. Unless you are certain of dying in 2010, you need to understand how this tax can affect you and your family, and what you can do to reduce or eliminate its impact on your assets.

Your estate will have to pay federal estate taxes if its net value when you die is more than the "exempt" amount set by Congress at that time. To determine the current net value of your estate, add your assets then subtract your debts. Be sure to include your home, business interests, bank accounts, investments, personal property, IRAs, and retirement plans. You must also include death benefits from any life insurance policies for which you have any "incidents of ownership." These include policies you can borrow against, assign or cancel, or for which you can revoke an assignment, or can name or change the beneficiary. If the net value of your estate is less than the exempt amount, you'll pay no estate taxes. But if it's more, every dollar over the exempt amount will be taxed.

So, what can you do to get the most out of the returning estate tax exemption, understanding that it might change several times over your lifetime?

1. Married? You can "double" your exemption. By setting up an A-B living trust, both spouses can use their estate tax exemptions. For example, let's assume the estate tax exemption is $1 million and the top tax rate is 55%, as it is scheduled to be in 2011. By using both of your exemptions, you and your spouse could protect up to $2 million from estate taxes, saving up to $435,000 in federal estate taxes. But you have to plan ahead to do this; otherwise, you waste one spouse's exemption...and that $4355,000 could go to Uncle Sam instead of to your family.

2. Check the wording. If you already have an A-B living trust, make sure the language to use your exemptions is flexible and does not state a specific dollar amount (e.g., $1 million or $2 million). Instead, it could apply a formula or use language such as "the amount that is exempt from estate taxes at the time of the grantor's death." Your attorney will know the best way to handle this. Note: Because there is no federal estate tax in 2010, this wording could cause your spouse to receive fewer resources than you intended. If you think you have this wording in your current plan, have your attorney review your document and make any necessary changes.

3. Shift assets. If you and your spouse have separate trusts, you may need to move assets from one trust to the other as the exemption increases or decreases.

4. Switch to a trust. If a will is your only estate plan, consider changing to a living trust now. It will probably cost more initially, but it can avoid probate, prevent court control of assets at incapacity, and will give you more control over the distribution of your estate after you die.

5. Make gifts. If you have a sizeable estate, you may want to consider giving some of your assets now to the people or organizations who will receive them after you die. Why? First, it can be very satisfying to see the results of your gifts -- something you can't do if you hold onto everything until you die. Second, gifting is an excellent way to reduce estate taxes because you are reducing the size of your taxable estate. (Just make sure you don't give away any assets you may need later.) There are right and wrong ways to do this. If this is something that interests you, check with your attorney before you make any gifts.

6. Remove assets from your estate at a discount. If your estate is larger than the exempt amount (or larger than two exemptions if you are married), your attorney can suggest some additional planning options that will let you transfer assets to your loved ones at reduced values, leveraging the amount of your exemption(s). Some of these options may be discontinued in the near future, as the IRS and many in Congress will be looking for more ways to increase tax revenues. So this is an excellent time to incorporate them in your planning, while they are still available.

7. Review your plan annually with a qualified attorney. Your estate plan is a snapshot of you, your assets, your family, your goals and the tax laws in effect at the time it was prepared. Any time one of these changes, you need to review your plan. This year is a perfect example of when you need to have your plan reviewed. With no estate tax, some current provisions may not work the way you intended and will need to be changed. Be prepared that additional changes may need to be made when Congress does act on the estate tax law.