Some maintain the estate tax is an effective way of redistributing wealth and encouraging charitable giving. Others argue that individuals who have worked hard to accumulate wealth should not have to pay a penalty to pass assets on to their heirs. These opposing arguments have turned the estate tax into a political football and created an environment of uncertainty that makes that area of financial planning something like trying to hit a moving target.
Estimating estate tax looks simple enough. You start with net worth--all assets minus liabilities. A single person can exempt $2 million and married couples can exempt $4 million. So a married couple with $5 million of net worth will have a $1 million estate taxable by the federal government at the rate of 46 percent.
But don't put away your calculators yet, because that rule of thumb only applies if you die in 2006. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) established a sliding rate scale. In 2007 and 2008, the exemption stays at $2 million, but the tax rate is reduced to 45 percent. In 2009, the exemption moves up to $3.5 million, but the tax rate remains at 45 percent. The optimum year to die, of course, is 2010--the year the estate tax is repealed. (However, there will be a top individual income tax rate for gifts ranging from 18 percent to 35 percent.) Barring congressional action to the contrary, the estate tax returns in 2011, with the exemption reduced back down to [the pre-EGTRRA rate of] $1 million and the maximum tax rate increased to 60 percent.
Put simply, the law as it stands is a nightmare for financial planners. "The law passed in 2001 made it very difficult to plan because you don't know when you're going to die," says Mark Rozell, chair of the New York State Society of CPAs.
Considering the amount of the exemptions, less than 1 percent of estates are subject to the federal estate tax, but that may change in the future. Estates are often larger than people think they are when life insurance, IRAs and the value of their house enter the mix. "It can sneak up on you, especially if you have any kind of life insurance policy," says Cal Brown, a CFP at the Monitor Group in McLean, Va.
A greater percentage of Americans are affected by their state estate or inheritance taxes. Many states--including New York, New Jersey and Connecticut--have tax rates of around 5 percent. And New York residents can claim only a $1 million state exemption, which is not scheduled to increase. So a New York resident with a $2 million estate may get relief from federal taxes, yet still have to pay $100,000 in state estate taxes.
Besides establishing residency in a tax-friendly state such as Florida, there are other options advisors can implement to help clients avoid or reduce the estate tax burden. The first step is the relatively simple one of updating clients' wills. If that is not done, they may end up paying considerably more estate tax than they should. They should also grant powers of attorney to those who can act on their behalf if they are disabled.
The next step is to make use of annual exclusion gifts. Individuals can give $12,000 a year tax-free to anyone; married couples can gift $24,000. Grandparents and parents might consider making five years of annual exclusion gifts (per child) upfront to 529 college savings plans. Gifts can also pay for uncovered medical expenses. Neither of these will reduce a donor's federal lifetime gifting exemption. (The medical gift, however, must go straight to the provider.)
In addition to the annual exclusion, individuals can take advantage of the one-time exclusion of $1 million; $2 million for married couples. Those who can afford to should use that during their lifetime. High-net-worth individuals in particular should try to transfer highly appreciated assets such as securities and real estate out of their estate.
Life insurance plays a key role. Although it does not reduce estate taxes, it can ensure that funds are available to pay them or support the surviving spouse and family. "Life insurance should never be owned individually," warns Bernie Rappaport, a tax partner at N.Y. accounting and consulting firm Anchin Block and Anchin. "It should be in a trust. If it's owned individually, it will be taxable in the estate."
And of course, trusts can be structured in many ways. With a by-pass trust, for instance, property goes into a trust upon the first death, and the trust is passed on to the heirs estate tax-free at the second death to gain the maximum federal exemption. In some states, heirs would have to pay a state estate tax at the first death, but at least they can avoid being taxed at 45 percent at the time of the second death.
Many practitioners advocate a disclaimer trust, whereby the surviving spouse has the flexibility and the option to set up a by-pass trust after the death of the first spouse. Assets may be put into that trust once the surviving spouse determines his or her needs and the exemption levels and tax rates at the time of the first death.
The life insurance trust is the last great tax shelter because an existing policy can be transferred to it, or a new policy may be purchased for the trust. Upon death of the insured, the proceeds are estate tax-free. However, heirs will not receive the tax benefit if the insured dies within three years of a policy transfer. One also needs to keep in mind that the life insurance trust is irrevocable.
A trust that is becoming more popular lately is the qualified personal residence trust (QPRT). (See a more extensive story about this on page 24.) Individuals may put their house or vacation home in a trust, maintaining the right to remain in the home for a given term. The gift to beneficiaries is calculated on an actuarial basis and is discounted from the total [fair market] value of the property. "Depending upon your age, you may get a nice discount on the gift, so you're only using up a portion of your lifetime exemption," Rozell explains. "At the end of the term, the property goes to your heirs."
The family limited partnership is appropriate for people with large estates, which might include real estate, marketable securities and/or a business. These assets can be put into the partnership and gifted to children over time. Upon the principle's death, the survivors benefit from discounts on the value of the entity of up to 40 percent, which means a lot less tax paid to the government.
With a charitable remainder trust individuals are able to put assets into the trust and receive income from it during their lifetime, with the principal going to a charity upon the donor's death. Similarly, one can set up a charitable lead trust, with the charity getting the income and the donor's heirs receiving the remainder on the donor's death.
"If you do it during [your] lifetime, you can get a charitable deduction for income tax purposes and you also get this property out of your estate for estate tax purposes," says Rozell. "That's a very effective vehicle if you're charitably oriented."
The most appropriate assets to put in a charitable remainder trust are those that are highly appreciated, such as stock. The donor receives an income tax deduction based on the fair market value and is not required to pay capital gains tax. This is clearly a better alternative than selling the assets, making the gift and paying the capital gains tax.
The grantor retained annuity trust (GRAT) works in a way that is similar to the Charitable Remainder Trust. The donor contributes assets to the trust and receives a payout over his/her lifetime, during which it serves as a discounted gift, and the assets are distributed to heirs upon the donor's death.
Finally, a qualified terminable interest trust (QTIT) provides for income to a spouse for life, with the remainder going to the heirs. On the first death, the surviving spouse gets a marital deduction, so there is no tax due on the income. The survivor maintains control of the assets, and the trust is not taxed until the second spouse dies. QTITs are often used in second marriages, so that children from a first marriage receive the money after the death of the surviving spouse.
It is important to build flexibility into the trust document so that at death, the executor can elect for an appropriate marital deduction. Let's say a husband has a $5 million estate which is put into a QTIT upon his death. The executor may elect to split the trust into a $3 million marriage deduction trust and a $2 million non-marital deduction trust--in effect, a by-pass trust. A New York resident, for instance, would then pay $100,000 in state estate taxes. But $2 million would have been removed from both estates because the money in the non-marital trust will go to the children estate tax-free.
Very often, it is worthwhile to pay that tax now rather than paying at a higher rate when the second spouse dies. Of course, under current law, if the second spouse dies in a year in which there is no estate tax, that deduction is wasted.
These are all good solutions to estate tax problems, but before getting into them, clients need to clarify their goals. Typically, estate-planning objectives fall into five categories, organized by objective:
o Financial independence for mom and dad until they die: If that is the number one goal, then there is no need to worry about taxes. oo Minimize or eliminate estate taxes: The individual can simply give away all assets above the exclusion amount.o Maximize the inheritance to heirs: If that is the intent, then the estate taxes may or may not be minimized.o Maximize charitable giving or, following the route recently announced by Bill Gates and Warren Buffet, establish a specific inheritance amount for each child and give the rest to charity. The goal here is not to give children so much money that it ruins their motivation.
"It's all about your objectives and philosophy," says Monitor's Brown. "It really becomes a balancing act of how much you want to give away, how much you want your heirs to get--and how much it makes you cringe when you count up the tax dollars that are going to the IRS."
Playing games on Capitol Hill
When Congress adjourned for the summer, lawmakers had still not settled the question of whether to extend, repeal or amend the estate tax exemptions established by EGTRRA in 2001.
Given lawmakers' indecision, estate tax planning is difficult. The tax could go away in 2010 and return with a higher exclusion of around $2 million to $5 million in 2011. Of course there is always the chance it will be repealed altogether.
All this dithering is fuel for procrastinators who start the estate planning process and, for various reasons, never finish. Popular excuses include difficulty in appointing a guardian for children or dealing with estranged offspring. It is not uncommon for an advisor to draft a life insurance trust and discover that the insured simply has no time to go for the physical.
Ironically, many wealthy individuals spend an enormous amount of time building up major estates and then neglect estate tax planning on a gamble that the law will be repealed. But as Neil Elmouchi, president of Summit Financial Consultants in Westlake Village, Calif., says, "They don't understand that the tax never goes away. It's just paid in a different way."
Elmouchi points out that some states can only charge an estate tax if there is an offset on the federal tax return. If the federal estate tax is repealed, those states will lose an important source of revenue. Not surprisingly, they are moving to change their laws to ensure they are not left with a significant shortfall.
Advisors such as Monitor Group's Cal Brown recommend taking a conservative approach. "If you're below $2 million and it is unlikely that you will ever get above $2 million, then we're not too worried about taking any major planning steps," says Brown. "If you're at $5 million already and above, then we're going to assume that there is going to be some kind of estate tax, and we're going to go ahead and put some plans into place."
Those who are proactive about estate planning can do something to counter the uncertainty. For starters, they should build flexibility into their will so the executor has choices. For instance, the surviving spouse might want to have the option to disclaim assets so they are passed through to the children.
Individuals should avoid paying gift taxes. In some circumstances, paying gift tax could reduce the estate tax, but generally, people should use the annual exclusion gifts or the lifetime exemption to make larger gifts. That way, they are not harmed even if the estate tax is repealed. The assets can be held safely in a trust until they are passed on to the children according to the trust's provisions.
They can also buy life insurance--available at bargain-basement prices over the last few years--to make sufficient funds available to pay the tax if it is not repealed. If the tax is repealed, they can simply stop paying the premiums on the policy or reduce the amount of insurance.--SD
Sherree DeCovny is the author of several books and reports on financial services and technology. Her work has appeared in leading journals in the U.S. and the U.K.