I. The Federal Gift Tax is alive and well in 2010 even though the Federal Estate Tax is in temporary repeal.
In the last segment, I introduced the basics behind the Federal Estate Tax and the fact of its return on January 1, 2011 if Congress takes no action before then. I also explained the Federal Gift Tax which prevents individuals from avoiding the Federal Estate Tax by simply giving enormous amounts of money to their children and grandchildren to avoid the Federal Estate Tax.
In 2001, when Congress enacted the legislation which gradually eliminated the Federal Estate Tax by 2010, Congress may actually have anticipated the events that are currently unfolding. Knowing that the Federal Estate Tax would return in 2011 absent an extension of the 2001 law, Congress did NOT eliminate the Federal Gift Tax. That effectively prevents individuals from giving away their wealth to future generations in 2010 while the Federal Estate Tax temporarily disappeared.
Is there any way to minimize the effect of the estate tax if Congress takes no action and the tax returns to pre-2001 levels? Yes.
II. The unlimited marital and charitable deductions.
The Federal Estate and Gift Tax allows for unlimited tax-free transfers between spouses as long as both spouses are United States citizens. This means that you can give unlimited wealth to your spouse during your lifetime without paying any gift tax. Likewise, you can leave unlimited wealth to your surviving spouse upon your death and pay no estate tax.
Most married couples already incorporate this deduction into their estate plans by simply designating each other as the primary beneficiary of each other's estate. In such cases, no estate tax is due upon the death of the first spouse because the surviving spouse inherits the entire estate. The theory behind this deduction is that the assets will ultimately be taxed once the surviving spouse dies and the assets pass to the children and/or grandchildren (or other beneficiaries of the married couple).
The same unlimited deduction is also available for gifts and bequests to charitable organizations. While there may be limitations on an income tax deduction for gifts to charity, there is no limitation on the deduction for purposes of the Federal Gift Tax and the Federal Estate Tax. Therefore, individuals making gifts to charity during their lifetime, or leaving assets to a charity upon death, can significantly reduce the size of their taxable estate. Use of charitable lead trusts, charitable remainder trusts, charitable gift annuities, and many other charitable gifting vehicles provide a number of tax advantages.
III. Shouldn't I just leave all of my assets to my surviving spouse to defer the payment of the Federal Estate Tax for as long as possible? NO!!
If Congress takes no action, and the Federal Estate Tax returns to 2001 levels, the unified credit amount for each person will effectively shield $1,000,000.00 in assets. This unified credit amount is not for each married couple; it is for each individual.
If it is for each individual, shouldn't each person take full advantage of his or her unified credit amount to shield more money from the Federal Estate Tax? The answer is obviously yes. However, as mentioned above, most married couples have a simplified estate plan that leaves the entire family estate to the surviving spouse; thus wasting one spouse's $1 million unified credit.
Confused? Here's a simple example. Sam and Judy are married and have 3 sons. Sam and Judy own a home, a checking account, savings account, some mutual funds, each has an IRA, and Sam owns a life insurance policy naming Judy as the beneficiary. Sam dies in January 2011 and Judy receives all of the assets. In July 2011, Judy dies. At the time of her death, all of the combined family assets have a value of $1,750,000. Her will provides for the estate to be divided equally among the three sons. Judy's estate will pay Federal Estate Tax at a rate of 37% of $750,000 (taking into consideration the $1 million unified credit that shelters the first $1 million from taxation). Judy's sons therefore get the privilege of paying the IRS approximately $277,500 in Federal Estate Tax. Ouch.
If Sam and Judy had planned better, their sons in the above example could have paid $0.00 in Federal Estate Tax. If Sam and Judy would have prepared credit shelter trusts before Sam's death, Sam's estate would have set aside the amount of $1 million in a credit shelter trust. The remaining assets ($750,000) could be available for Judy's unrestricted use. For even more flexibility, the credit shelter trust can be drafted in order to allow Judy to use the income and some of the principal of the credit shelter trust should she actually need it. The ultimate beneficiaries of the credit shelter trust (upon Judy's death) are the 3 sons. Upon Judy's death, the $1 million credit shelter trust created upon Sam's death, as well as the $750,000 that is owned by Judy upon her death pass to the three sons free of any Federal Estate Tax. Sam's unified credit of $1 million was used to shelter the first $1 million. Judy's unified credit of $1 million was used to shelter the remaining $750,000.
IV. I'm not a millionaire, so I don't need to worry.
These numbers may appear very significant, but when you stop to think about all of the assets that are included in an estate tax caluclation, you may actually have something to worry about.
Do you have a large life insurance policy? If you have a life insurance policy, through your employer or one you purchased yourself, the death benefits from that policy are included in the estate tax. Do you own a home? The equity in that home is included in the estate tax. Have you been saving for retirement in an IRA or employer-sponsored plan? Include all those assets as well. Your bank account balances, investments (including stocks, bonds, and mutual funds), and any real estate is included. Own a small business or a farm? The appraised value of that business or farm is included in the estate tax as well. Are you close to or over $1 million yet? Have you considered how much you want to pay in Federal Estate Tax?
In Part 3, we will discuss some other planning methods to reduce or minimize the Federal Estate Tax.
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