No Federal Estate Tax? Not a Chance

EDITOR'S NOTE: This article was originally published in the February 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.

Congress missed the deadline when it came to dealing with the federal estate tax. Despite more than eight years' notice, lawmakers allowed the estate tax to die on December 31. That levy -- which claimed 45% of the amount of an estate exceeding $3.5 million in 2009 -- has disappeared in a triumph for opponents who have long condemned the "death tax."

Although that might sound like cause for celebration, contain yourself. If Congress continues to do nothing, the estate tax will come back to life with a vengeance in 2011. As the law now stands, in 2011, just $1 million will pass to heirs tax-free, and bigger estates will be taxed at a top rate of 60%. What's more, a complicated new tax rule came into play on January 1 that requires some heirs to pay tax on profit from inherited assets that have long been tax-free.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

At Kiplinger's, we expect that Congress will reinstate the estate tax and eliminate the complicated alternative. In the meantime, we've pulled together these questions and answers to help you navigate the treacherous waters ahead.

How did the rules work? A husband or wife could leave any amount to a spouse free of estate tax. For bequests to others, in 2009, everyone could leave assets of up to $3.5 million tax-free. Above that level, a 45% tax applied. The high exemption level meant few estates -- by one estimate, less than 15,000 -- actually owed the tax.

What replaces the estate tax for 2010? To understand the alternative, you must know the stepped-up basis rule. The old law set the tax basis of inherited assets at their value on the date of death of the owner. Because that new basis was generally higher than the owner's basis, the step-up effectively forgave the tax on any appreciation before the owner's death. If stock that someone bought for $10 was worth $100 when he or she died, $100 became the tax basis for the person who inherited the stock. The heir owed tax only if he or she sold the stock for more than $100.

As the law stands now, heirs are allowed to take a step-up in basis for only $1.3 million of appreciation. A surviving spouse can take an extra $3 million step-up. This means the tax can be forgiven on only $4.3 million of appreciation.

For any excess, in 2010, heirs are stuck with carry-over basis, meaning their basis is the same as the original owner's. When the heirs ultimately sell the assets, they'll pay tax on appreciation during the previous owner's life. In the example above, if you inherit that $100 stock, your basis would be $10, and you'd owe capital-gains tax on the $90 of appreciation when you sell. So the estate tax is being replaced by a capital-gains tax on some beneficiaries.

The executor is charged with deciding which assets get a stepped-up basis and which do not. The executor's decisions could lead to fights among heirs, some of whom will receive a tax break and some of whom may not. Another hellacious problem will be reconstructing the original owner's basis for the assets stuck with carryover basis.

Did the federal gift tax expire, too? That tax lives on, but at a lower rate. As in 2009, you can give up to $13,000 to any number of recipients each year without having to worry about the gift tax. For gifts above that amount, everyone has a credit that covers the tax on the first $1 million of gifts. For 2010, the top rate on taxable gifts is 35%, down from 45% last year.

What does Kiplinger's think will happen? We expect that Congress will retroactively reinstate the federal estate tax in a form similar to the law that applied for 2009. However, the exemption amount may be raised to as high as $5 million, and the top rate may fall from 45% last year to 35% going forward.

The U.S. Supreme Court has allowed retroactive tax changes. Congress frequently approves tax decreases retroactively. Although a law reinstating the estate tax would likely be challenged in court, we doubt such a challenge would prevail.

For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger’s Retirement Report.