Easing the Estate-tax Burden

By Mitchell J. Fielding
Analyst, mPower

In This Story The First $675,000 Is "Free" Charitable Gifts Community Property The Bypass Trust Sophisticated Strategies

Estate tax was originally implemented during the Civil War to pay for the conflict's enormous costs. Levied on top of the income tax you pay as you earn your wealth, and the capital gains tax you pay as you build your wealth, estate tax, paid when your wealth is finally distributed to others, could be the most expensive tax you'll ever pay.

Fortunately, you have a number of tools at your disposal to keep the majority of your estate from going to the IRS. The final installment of our three-part series on estate planning takes a look at some of them.

minute: read this article at a glance.

One of the first questions people ask about estate tax is, what in my "estate" gets taxed?

The answer is fairly simple: All property, including stocks, real estate, cars, certificates of deposit ("CDs"), life insurance policies, art, and furniture, are included in your taxable estate (all assets owned at the time of death).

The IRS values your property at its fair market value on the date of death. If your estate is valued at more than $675,000, it is subject to estate taxation. Further, if you are "asset rich and cash poor" your heirs may be forced to sell your property in order to pay estate taxes.

Thoughtful estate planning can often lessen the burden on your heirs.

Keep in mind that estate-planning strategies range from the straightforward to the very complex. We recommend consulting an estate-planning advisor, either an estate attorney or financial planner.

The first thing you have to determine is if you will be liable for estate taxes.

The First $675,000 Is "Free"

Until 1997, the first $600,000 of your estate was exempt from taxation. Congress, in the Taxpayer Relief Act of 1997, implemented a series of annual increases to the exemption amount.

In the year 2000, the first $675,000 of your estate is exempt from estate tax. By 2006, if Congress continues with its plan, the exemption amount should equal $1,000,000.

With such exemption levels, why worry about estate tax? Because, depending on the real-estate values where you live, and the assets you accumulate throughout a lifetime, you may be surprised at not only what your taxable estate will ultimately total, but also the corresponding size of your estate-tax bill.

With the IRS' current estate-tax rates, any amount over $675,000 is taxed at a rapidly increasing rate, beginning at 18% and increasing to 60%. It hits home how painful this tax burden could be if you compare those rates with the income tax rate, which begins at 15% and increases to 39.6%, of your adjusted gross income.

Depending on the real-estate values where you live, and the assets you accumulate throughout a lifetime, you may be surprised at not only what your taxable estate will ultimately total, but also the corresponding size of your estate-tax bill.

The majority of estate-tax–minimizing strategies involve removing assets from the estate. One such method is making charitable gifts.

Charitable Gifts

The size of your taxable estate can be reduced by making charitable gifts. You can make these gifts directly in your will or trust, naming a specific organization as beneficiary.

Any gift you make will be valued at its fair market value as of the date of your death.

For example, if Susan decides to gift her $20,000 worth of XYZ.com stock to Guide Dogs for the Blind, her estate would get a $20,000 charitable deduction, regardless of how much she paid for the stock. And, if she wanted to make a gift of other pricey items, such as donating her lake house and boat to the Boys and Girls Clubs of America, these would also reduce the amount in her taxable estate by their market values.

Community Property

A very simple method of saving your surviving spouse a tremendous amount of tax liability is to retitle your home and other assets in community property instead of joint tenancy.

Most realtors recommend that married couples title their homes in joint tenancy so the property will not go through probate. However, for those who live in community property states, Congress gives you a potential estate-tax break if your property is titled as community property.

"Basis" is the value from which you calculate capital gains to be taxed. It is an asset's initial cost, decreased by depreciation, or increased by improvements.

This break revolves around "basis," or how the asset is valued, for the purpose of calculating the gain that will be taxed when the survivor sells the asset. A higher basis will mean a lower gain and a lower tax.

For a joint tenant whose partner dies, the basis will be half of what the couple initially paid for the asset, plus half of the asset's value at the time the partner dies. However, for a community-property owner the basis is the value of the entire asset at the time the partner dies.

For example, let's say Hugo and Wilma buy a house for $100,000 in 1975. They hold it in joint tenancy and the house has appreciated to $1,250,000 when Hugo passes away.

To increase your basis, and therefore decrease your taxable gain upon sale of your house, save those home-improvement receipts to prove the increase in value!

Wilma's basis will be $50,000 for her half of the house, plus $625,000 for Hugo's half of the property that he left her when he died. This leaves Wilma a new $675,000 basis.

If Wilma sells the house for $1,250,000, she will have a taxable gain of $575,000. However, the IRS allows taxpayers to exclude $250,000 in gain from the sale of a house ($500,000 if you're married). Therefore, Wilma's taxable gain is actually $325,000 ($575,000 minus $250,000).

The tax rate on a sale of a personal residence is 20%. Wilma's tax would be 20% of her $325,000 taxable gain, which equals $65,000.

So, for this hypothetical example, if Wilma and Hugo hold their house in joint tenancy, Wilma pays $65,000 in tax.

If, by contrast, Hugo and Wilma had simply retitled the home as community property, Wilma's new basis on the home would be $1,250,000, the value of the home on the date of Hugo's death. Wilma could then turn around and sell it for that amount without realizing any taxable gain.

If Wilma and Hugo hold their house in community property, Wilma pays no tax.

By using community property, you may leave your spouse an unlimited amount of property tax free. Which lucky states allow community property?

The Bypass Trust

Another strategy that reduces estate tax is the bypass trust. By using community property, you can leave your spouse property tax free. However, if Hugo leaves everything to Wilma, then upon her death, she can in turn only leave up to $675,000 without incurring any estate tax. That will include Hugo's assets that she inherited.

Using the bypass trust, Hugo can leave $675,000 to someone other than Wilma, say their children. Separately, Wilma can also leave $675,000 (or more, if she dies later when the exemption is higher). So, Hugo and Wilma, as a married couple, could leave a total of at least $1,350,000 without incurring any estate tax.

Unfortunately, this entails personally leaving your spouse $675,000 less.

Fortunately, in the bypass trust, tax law allows your surviving spouse to have access to the entire estate.

Wilma can draw income from the trust and draw on the trust's principle if necessary. The net effect of such a strategy is to double up on the exemption, allowing each spouse to transfer up to $675,000 (or more, in future years) out of their respective estates without losing access to the assets in the estate.

Sophisticated Strategies

The simplest fact about estate planning, but also the most crucial, is that estate tax is levied on the taxable estate (all assets owned at the time of death).

Therefore, the majority of estate-tax–minimizing strategies involve removing assets from the taxable estate. More sophisticated strategies than the ones discussed above might include family-limited partnerships, generation-skipping transfer trusts, and qualified personal-residence trusts.

These are very situation-specific strategies that focus on removing your property from your control. They should be approached carefully, and an estate attorney should be consulted.

The most fundamental estate-tax saving strategy, although relatively easy, involves some work: shopping for an estate-planning professional.

A certified professional — financial planner, public accountant, or even a registered representative — can help in designing an estate plan. But, the only people allowed to draft documents for your estate are you or your attorney. It's a good idea to consult an attorney when drafting documents.

It is also good to remember that registered representatives and insurance agents may represent a firm that sells products touted as estate-planning strategies, such as annuities; whereas certified financial planners and certified public accountants work independently of such relationships.

A certified professional — financial planner, public accountant, or even a registered representative — can help in designing an estate plan ... but when drafting documents, an estate attorney should be consulted.

There are several ways to start looking for estate-planning help. If you have friends or acquaintances who had complicated estate planning done, ask for the name of their estate planner. Or, contact your state's bar association for a reference for an estate attorney. You can also get help in finding an estate-planning professional from the Financial Planning Association.

Make sure you consult several professionals before choosing one you feel most comfortable with and who is responsive to your family's specific needs. An estate-planning professional should tailor a plan that is sophisticated enough to suit individual needs as well as overall family concerns.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Easing the Estate-tax Burden

By Mitchell J. Fielding
Analyst, mPower

In This Story The First $675,000 Is "Free" Charitable Gifts Community Property The Bypass Trust Sophisticated Strategies

Estate tax was originally implemented during the Civil War to pay for the conflict's enormous costs. Levied on top of the income tax you pay as you earn your wealth, and the capital gains tax you pay as you build your wealth, estate tax, paid when your wealth is finally distributed to others, could be the most expensive tax you'll ever pay.

Fortunately, you have a number of tools at your disposal to keep the majority of your estate from going to the IRS. The final installment of our three-part series on estate planning takes a look at some of them.

minute: read this article at a glance.

One of the first questions people ask about estate tax is, what in my "estate" gets taxed?

The answer is fairly simple: All property, including stocks, real estate, cars, certificates of deposit ("CDs"), life insurance policies, art, and furniture, are included in your taxable estate (all assets owned at the time of death).

The IRS values your property at its fair market value on the date of death. If your estate is valued at more than $675,000, it is subject to estate taxation. Further, if you are "asset rich and cash poor" your heirs may be forced to sell your property in order to pay estate taxes.

Thoughtful estate planning can often lessen the burden on your heirs.

Keep in mind that estate-planning strategies range from the straightforward to the very complex. We recommend consulting an estate-planning advisor, either an estate attorney or financial planner.

The first thing you have to determine is if you will be liable for estate taxes.

The First $675,000 Is "Free"

Until 1997, the first $600,000 of your estate was exempt from taxation. Congress, in the Taxpayer Relief Act of 1997, implemented a series of annual increases to the exemption amount.

In the year 2000, the first $675,000 of your estate is exempt from estate tax. By 2006, if Congress continues with its plan, the exemption amount should equal $1,000,000.

With such exemption levels, why worry about estate tax? Because, depending on the real-estate values where you live, and the assets you accumulate throughout a lifetime, you may be surprised at not only what your taxable estate will ultimately total, but also the corresponding size of your estate-tax bill.

With the IRS' current estate-tax rates, any amount over $675,000 is taxed at a rapidly increasing rate, beginning at 18% and increasing to 60%. It hits home how painful this tax burden could be if you compare those rates with the income tax rate, which begins at 15% and increases to 39.6%, of your adjusted gross income.

Depending on the real-estate values where you live, and the assets you accumulate throughout a lifetime, you may be surprised at not only what your taxable estate will ultimately total, but also the corresponding size of your estate-tax bill.

The majority of estate-tax–minimizing strategies involve removing assets from the estate. One such method is making charitable gifts.

Charitable Gifts

The size of your taxable estate can be reduced by making charitable gifts. You can make these gifts directly in your will or trust, naming a specific organization as beneficiary.

Any gift you make will be valued at its fair market value as of the date of your death.

For example, if Susan decides to gift her $20,000 worth of XYZ.com stock to Guide Dogs for the Blind, her estate would get a $20,000 charitable deduction, regardless of how much she paid for the stock. And, if she wanted to make a gift of other pricey items, such as donating her lake house and boat to the Boys and Girls Clubs of America, these would also reduce the amount in her taxable estate by their market values.

Community Property

A very simple method of saving your surviving spouse a tremendous amount of tax liability is to retitle your home and other assets in community property instead of joint tenancy.

Most realtors recommend that married couples title their homes in joint tenancy so the property will not go through probate. However, for those who live in community property states, Congress gives you a potential estate-tax break if your property is titled as community property.

"Basis" is the value from which you calculate capital gains to be taxed. It is an asset's initial cost, decreased by depreciation, or increased by improvements.

This break revolves around "basis," or how the asset is valued, for the purpose of calculating the gain that will be taxed when the survivor sells the asset. A higher basis will mean a lower gain and a lower tax.

For a joint tenant whose partner dies, the basis will be half of what the couple initially paid for the asset, plus half of the asset's value at the time the partner dies. However, for a community-property owner the basis is the value of the entire asset at the time the partner dies.

For example, let's say Hugo and Wilma buy a house for $100,000 in 1975. They hold it in joint tenancy and the house has appreciated to $1,250,000 when Hugo passes away.

To increase your basis, and therefore decrease your taxable gain upon sale of your house, save those home-improvement receipts to prove the increase in value!

Wilma's basis will be $50,000 for her half of the house, plus $625,000 for Hugo's half of the property that he left her when he died. This leaves Wilma a new $675,000 basis.

If Wilma sells the house for $1,250,000, she will have a taxable gain of $575,000. However, the IRS allows taxpayers to exclude $250,000 in gain from the sale of a house ($500,000 if you're married). Therefore, Wilma's taxable gain is actually $325,000 ($575,000 minus $250,000).

The tax rate on a sale of a personal residence is 20%. Wilma's tax would be 20% of her $325,000 taxable gain, which equals $65,000.

So, for this hypothetical example, if Wilma and Hugo hold their house in joint tenancy, Wilma pays $65,000 in tax.

If, by contrast, Hugo and Wilma had simply retitled the home as community property, Wilma's new basis on the home would be $1,250,000, the value of the home on the date of Hugo's death. Wilma could then turn around and sell it for that amount without realizing any taxable gain.

If Wilma and Hugo hold their house in community property, Wilma pays no tax.

By using community property, you may leave your spouse an unlimited amount of property tax free. Which lucky states allow community property?

The Bypass Trust

Another strategy that reduces estate tax is the bypass trust. By using community property, you can leave your spouse property tax free. However, if Hugo leaves everything to Wilma, then upon her death, she can in turn only leave up to $675,000 without incurring any estate tax. That will include Hugo's assets that she inherited.

Using the bypass trust, Hugo can leave $675,000 to someone other than Wilma, say their children. Separately, Wilma can also leave $675,000 (or more, if she dies later when the exemption is higher). So, Hugo and Wilma, as a married couple, could leave a total of at least $1,350,000 without incurring any estate tax.

Unfortunately, this entails personally leaving your spouse $675,000 less.

Fortunately, in the bypass trust, tax law allows your surviving spouse to have access to the entire estate.

Wilma can draw income from the trust and draw on the trust's principle if necessary. The net effect of such a strategy is to double up on the exemption, allowing each spouse to transfer up to $675,000 (or more, in future years) out of their respective estates without losing access to the assets in the estate.

Sophisticated Strategies

The simplest fact about estate planning, but also the most crucial, is that estate tax is levied on the taxable estate (all assets owned at the time of death).

Therefore, the majority of estate-tax–minimizing strategies involve removing assets from the taxable estate. More sophisticated strategies than the ones discussed above might include family-limited partnerships, generation-skipping transfer trusts, and qualified personal-residence trusts.

These are very situation-specific strategies that focus on removing your property from your control. They should be approached carefully, and an estate attorney should be consulted.

The most fundamental estate-tax saving strategy, although relatively easy, involves some work: shopping for an estate-planning professional.

A certified professional — financial planner, public accountant, or even a registered representative — can help in designing an estate plan. But, the only people allowed to draft documents for your estate are you or your attorney. It's a good idea to consult an attorney when drafting documents.

It is also good to remember that registered representatives and insurance agents may represent a firm that sells products touted as estate-planning strategies, such as annuities; whereas certified financial planners and certified public accountants work independently of such relationships.

A certified professional — financial planner, public accountant, or even a registered representative — can help in designing an estate plan ... but when drafting documents, an estate attorney should be consulted.

There are several ways to start looking for estate-planning help. If you have friends or acquaintances who had complicated estate planning done, ask for the name of their estate planner. Or, contact your state's bar association for a reference for an estate attorney. You can also get help in finding an estate-planning professional from the Financial Planning Association.

Make sure you consult several professionals before choosing one you feel most comfortable with and who is responsive to your family's specific needs. An estate-planning professional should tailor a plan that is sophisticated enough to suit individual needs as well as overall family concerns.

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.