Under current law, the federal estate tax is scheduled to rise from the ashes on January 1, 2011, and begin attacking the affluent middle class along with the wealthy. People who didn't have to pay much attention to this tax in recent years will need to make it part of their financial planning. And it's not too soon to start taking the necessary steps.
Come next year, the amount of each estate that is exempt from tax will be just $1 million, and the tax on the rest will be 55% (60% in some cases). That means a lot more families will be affected by the tax than in 2009, when the tax-free amount was $3.5 million and the
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rate was 45%. Congress could change this plan, put in place a decade ago as part of the Bush tax cuts, but recent events make that increasingly unlikely.
As in the past, assets left to a spouse or to charity won't be subject to the tax. But a widow or widower with a home and a retirement account could easily be leaving more than $1 million to children, and that inheritance would be taxed. Unmarried and same-sex married couples will be particularly hard hit since they do not enjoy the estate tax breaks available to spouses.
Many strategies to reduce the government's take involve giving away assets while you are alive - something not everyone can afford to do. For those prepared to shed some wealth that way, there are gift tax rules to navigate. The gift tax, which is currently 35% and will rise to 55% next year, applies to certain transfers that exceed the $1 million limit on lifetime gifts. Note that if you use any part of the $1 million amount, it gets subtracted from the estate tax exemption that's available when you die. (For more insight, see Gifting Your Retirement Assets To Charity.)
So what can you do now? The following simple strategies can help you avoid blunders that would trigger tax unnecessarily, and minimize Uncle Sam's share of what you leave behind.
Maximize annual gifts.
Anyone can give cash or assets worth up to $13,000 a year to anyone else without it counting against that $1 million lifetime gift exemption. Married couples can combine their yearly gifts to give away up to $26,000 to as many people as they like. For example, a couple with an adult child who is married and has two children could make a joint cash gift of $26,000 to the adult child, the child's spouse and each grandchild - four people - providing the family with $104,000 a year.
Review life insurance policy ownership.
If you or your spouse own policies on your own lives, the proceeds could be subject to estate tax. One way to avoid that result is to designate the family member who will receive the proceeds of the policy - say, an adult child - as the owner of the policy. And using your yearly $13,000 gift exclusion, you can give them the money to pay the premiums.
If you don't want these beneficiaries to receive the insurance proceeds outright, you can set up an irrevocable life insurance trust. Typically the ILIT buys the policy and, when you die, holds the proceeds for whomever you've named as beneficiary or beneficiaries. As with any trust, you can set conditions on the use of the money - perhaps, for example, it's to go for the payment of your children's or grandchildren's college expenses.
With this set-up too, you can make annual gifts to finance the premiums, but there's a caveat: One condition for the annual exclusion is that the gift must be a present interest, meaning something the recipient can use right away, rather than a future one. The most common way to satisfy this requirement is to give beneficiaries Crummey powers - the right for a limited time, usually 30 or 60 days, to withdraw from the trust the yearly gift attributable to that beneficiary.
Each year, the trustees must send a notice, called a Crummey notice, to the beneficiaries (or the parents, if the beneficiaries are minors) letting them know about their right to withdraw their portion of the annual gift to the trust. (Crummey was the name of the family which first got the court's blessing to use annual gifts this way.)
If you already own a policy, you can transfer it to the trust. Warning: If you die within three years of making the transfer, the proceeds would generally be included in your estate. A work-around with term policies is to let the original policy lapse and have the ILIT buy a new one.
Put some assets in your own name.
The estate tax exemption applies to each of us personally - it's not something that we share with a spouse or partner. So to use it, you must have assets of your own. Jointly held property (for example, real estate or bank accounts titled joint tenants with right of survivorship) doesn't count because when one owner dies, full ownership automatically passes to the other. (For more on asset titling traps, click here.)
Unromantic as it may sound, look over your balance sheet to determine whether any property should be transferred from one spouse or partner to the other or out of joint ownership into the name of one of you individually. Unfortunately, this strategy doesn't work for retirement accounts - you can't give them away while you are alive.
Another consideration: unless you are shifting assets to a spouse who is a U.S. citizen, you may have to pay gift tax. Remember, you are allowed to give $13,000 in cash or other assets per year to each individual. For gifts to a non-citizen spouse, the yearly limit is $134,000.
Fund college savings.
A popular use of the annual exclusion is to put money in Section 529 state college savings plans. You can set up a separate account for each family member you want to benefit. Money in these accounts grows tax-free and can be withdrawn tax-free, provided it is used to pay for college, a graduate, vocational or another accredited school, or for related expenses, including books and, under certain circumstances, room and board.
The law permits lump-sum deposits of as much as $65,000 a person at once ($130,000 for married couples), provided you file a gift-tax return that treats the gift as if it had been spread over five years. If you die before the five years is up, the part of the gift that reflects the number of years still to go will be considered part of your estate.
Another unique feature of these plans is that you can tap into the funds yourself. Especially for people who don't want to give money away because they are afraid it will leave them short, this provides a measure of comfort. Just be aware that any sums you withdraw for non-college uses are subject to income tax and a 10% penalty on previously untaxed earnings. (No, you can't just take back your original contributions.) (For more insight, see Choosing The Right Type Of 529 Plan.)
Pay tuition and medical expenses.
Without using any of your $13,000 annual exclusion, you can pay for tuition, dental and medical expenses for anyone you want. But you must make the payments directly to the providers of those services - you can't just reimburse the people who you are benefiting. Many people don't realize the same rule also allows you to pick up some really big-ticket health care expenses, including health insurance premiums, orthodontia, medically necessary home improvements or home-care attendants.
Consider a Roth conversion.
Especially if you want to leave retirement assets to family or friends, a Roth conversion is one of the simplest, best planning tools available. You avoid the requirement to take yearly minimum distributions starting at age 70 and a half, which can leave more for beneficiaries if you don't use the money yourself. And subject to certain restrictions, no tax is assessed when the money is withdrawn, so income can compound tax-free.
Starting this year, you can do a conversion regardless of your income. You owe income tax on the amount you convert, which can be the entire account balance of your IRA or part of it. For conversions done in 2010, the law gives you a choice of when to pay the tax. One possibility is to count the amount converted as 2010 income and pay a lump sum. The other option is to divide the income equally in the following two years, in which case you must use installments - half with your 2011 income tax return and the remainder with the 2012 one, at the rates in effect for each of those years.
A Roth conversion does not eliminate estate tax - a common misconception. But by essentially prepaying the income tax for your heirs, you will have made them an enormous gift, and one that the government will not tax. The bottom line: When you leave your heirs a Roth, you do them a big favor.