New Estate Tax Schedule Provides Limited Relief To Many

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On the surface, it appears that many people will be protected from estate taxes in the coming years as the changes enacted by Congress this year become effective. A couple with less than $4 million might expect that their near term tax bill will be modest because of lower rates and, with the exclusion rising to $2 million by 2006, believe they will soon be estate tax-free, but that is something of an illusion.

The top federal marginal rate drops from 55% (60% for those estates subject to the 5% surtax) to 45% by 2009. The federal credit for state death taxes will be phased out by 2005. As a result, the top effective tax rate on residents of states that rely on the federal credit will be the new lower federal rate.

Arguably, the federal estate tax rate reductions are being paid for by the states. Exhibit 1 shows the impact of state death taxes on the federal rate. Through 2004 there is at least a partial credit for taxes paid to a state. Beginning in 2005, there is a deduction available if state taxes are paid.

However, in many states the only tax at death is a tax equal to the federal credit available on the date of the death. As the credit shrinks and then disappears, so will these state death taxes.

But what would happen if a states tax was tied to the current credit and is not phased out along with the federal credit? In Exhibit 1, when we add the top credit-based state marginal rate of 16% to the adjusted federal rate, the effective rate returns to its current range.

At least one state, New York, has a credit-based tax that will not phase out. As other states begin to recognize that the lower federal rates come, effectively, at their expense, they may be tempted to follow New Yorks example.

Just as the lower rates will prove to be an illusion to New Yorkers, the exclusions created by the greatly increased unified credit may also be an illusion for many. As an example, lets take a couple in their early 50s with a $3.75 million estate. Under current law, this is an estate in need of estate planning and life insurance to help pay estate taxes. At first blush, the need for life insurance appears to be temporary. After all, in 2006, the $2 million exclusion will shield their estate from the estate tax.

However, by 2006, the estate will likely exceed $4 million simply due to growth. And to further frustrate our estate owners, they may find that they cannot fully use the exclusions. Both husband and wife must own $2 million in assets in order to take full advantage of the exclusion, but many assets cannot be divided.

Today, many people are exposed to estate tax primarily because they own significant qualified plan assets. Suppose the husband owns a medical practice worth $750,000 and a 401(k) worth $2 million. That leaves $1 million to place in the wifes name since she cannot own his 401(k) or his medical practice.

Starting in 2004, the tax bill will be higher (see Exhibit 2, Columns A&B) if the wife dies first because she cannot fully utilize the credit. If the couple happens to live in New York, the tax bill is even higher (see Exhibit 2, Columns C&D) when we add the state tax.

Rather than a temporary need for life insurance, this couple might plan on keeping $1 million of second-to-die in force for the foreseeable future. This is especially true since under the law as it stands right now, their tax bill jumps up to over $2 million in 2011.

So far, we have assumed that the husbands 401(k) will, at least in part, end up in a credit shelter trust, as his estate fully utilizes the available unified credit, but that may not be good planning. The wife makes the best designated beneficiary for the 401(k). She can delay forced distributions from the plan until her husband would have been 70 1/2, whereas the credit shelter trust cannot. If she does not need the money, it makes no sense to accelerate the payment of income tax in order to reduce estate taxes, perhaps decades into the future.

Columns E&F show us what happens to the estate tax bill if the wife is the designated beneficiary of the 401(k). If the husband dies first, the couples exposure to estate tax increases significantly. The $1 million of second-to-die coverage makes even more sense.

The changes in the estate tax may turn out to be far less than meets the eye. The top marginal rate is not going down in New York and may not elsewhere. The large exclusions may not be there for many simply because of the type of assets they own. Estate planning and life insurance will continue to be important to a great many taxpayers.

, JD, LLM, is an advanced underwriting attorney based in Chatham, Mass.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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