The Estate-Tax Puzzle is Becoming Clearer

EDITOR'S NOTE: This article was originally published in the April 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.

Notice to anyone who has been using the uncertainty surrounding the federal estate tax as an excuse to avoid estate planning: The jig is up! Ironic as it may seem amid all the uncertainties of this election year, the future of the estate tax is more certain now than it has been in years.

A quick refresher course: Back in 2001, Congress passed a law to phase out the tax. The amount Americans can pass to their heirs tax-free was set to rise from $675,000 in 2001 to $3.5 million by 2009 (it's $2 million this year). Then, in 2010, the estate tax was supposed to expire. But there was a catch: The tax was also scheduled to rise from the dead in 2011 with a paltry $1 million exemption.

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That seesaw scenario is what had a lot of people pulling out their hair instead of planning. Although the schedule is still in place, it's clear that it will never happen. Why not? The next president is against it. John McCain and Barack Obama oppose repeal of the estate tax.

Obama would let the $3.5 million exemption continue; McCain would prefer a $5 million exemption. Because the law allows married couples to double the tax-free amounts, it's likely that, in the future, couples could leave their heirs a minimum of $7 million -- and maybe up to $10 million -- before Uncle Sam gets a bite of their assets.

What about the one-year estate-tax hiatus in 2010? "It ain't going to happen," says William Kirchick, an estate-tax lawyer with Bingham McCutchen, in Boston. "It's not a reality, and it was never intended to be." By the end of next year, Kirchick expects Congress to okay a tax-free amount for 2010 of at least $3.5 million, and perhaps $5 million.

A more contentious issue is likely to be the top estate-tax rate. Now 45%, some observers see the rate falling to 35% or even lower, while others believe it may be pushed back up to the 55% rate in effect before the 2001 tax changes.

Few Need Fear the Estate Tax

The higher exemptions mean fewer Americans than ever need to worry about the estate tax. In 2006, when the exemption was the same $2 million it is today, fewer than 3,000 estates actually owed the tax.

Still, it's important to establish an estate plan, which starts with writing a will and may include a medical directive and trusts. "Even if you're not subject to federal estate taxes, you need to have a plan to pass on the wealth and the control of assets," says Don Chapin, an elder-law lawyer with Chapin Law Offices, in Dublin, Ohio.

If you do face a potential estate-tax bill, planning can help reduce the amount hit by the 45% rate. You can give any number of people up to $12,000 a year without paying gift taxes. Beyond the annual gift-tax-free allowance, you can give away up to $1 million gift-tax-free during your lifetime. "All the value of the gift, and the income and appreciation of what you give away, is no longer in your estate," says Thomas Campbell, an estate-planning lawyer with Yates, Campbell, Christopher & Yates, in Fairfax, Va.

If you're married and your estate is likely to fall in the taxable range, a planner will likely recommend a credit-shelter or bypass trust. If a husband leaves his entire estate to his widow, the amount would pass tax-free thanks to an unlimited marital exemption. Without a credit-shelter trust, when the widow dies, only the exemption amount ($2 million this year) could go tax-free to the children.

With the bypass trust, the husband could leave the exemption amount in trust to the children, with the trust income going to the widow. When she dies, the children would get the money from the trust estate-tax-free and Mom could also leave them the exemption amount estate-tax-free. If both parents died in a year the exemption amount was $3.5 million, a total of $7 million would go to heirs estate-tax-free.

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