Friday, June 17, 2005

Will You Owe Estate Tax at Your Death?

Many people worry that they will owe estate tax at their death, but the reality is that fewer than 1% of all Americans will ever be subject to the estate tax. This is especially true (at least for the next few years) as a result of the sweeping tax law changes that took effect in 2001. Let's take a brief look at the most important provisions of the effect that new law had on the estate tax.

In looking at these changes, it helps to understand the following facts:

1. The Estate Tax Exclusion. Each individual has an exclusion against estate tax which is currently $1.5 million. This means that if you died today as a single person, and had less than $1.5 million in assets, then you would not be subject to the federal estate tax (whether you would be subject to your state's inheritance tax depends on your particular state's laws--in Texas, for example, you would pay no state inheritance tax if there were no federal estate tax paid). If you had assets in excess of $1.5 million, you would pay tax on the excess assets over $1.5 million, up to a top rate of 47%. However, the marginal rate for estates that barely exceed the exclusion amount would only be about 15-20%.

2. The Marital Deduction. If you are married, any gifts that you make to a surviving spouse entitles you to a deduction equal to the gift. Thus, if you and your spouse had $4 million in combined assets, and your share of the assets was $2 million, then you would be $500,000 over the exclusion amount. A gift to your spouse of all of your assets would reduce your estate to $0 because of the deduction ($2 million in assets less the $2 million gift to spouse = $0 estate for estate tax purposes). The problem with making an outright gift like this to the surviving spouse is that you have wasted your exclusion against the estate tax and your spouse now includes the full value of the assets you gave to him or her as part of their estate at their death, with only their exclusion to apply against the potential tax. In a future post, I will talk about eliminating this problem by utilizing a trust for the benefit of the surviving spouse that protects your exclusion while providing for your spouse's benefit at the same time.

From the inception of the law in 2001 through 2009 here's how the estate tax changes year by year depending on the year of death:

Year Exclusion Highest Rate
2001 $675,000 55%
2002 $1 Million 50%
2003 $1 Million 49%
2004 $1.5 Million 48%
2005 $1.5 Million 47%
2006 $2 Million 46%
2007/08 $2 Million 45%
2009 $3.5 Million 45%

If you die in the year 2010, there is no estate tax. The tax is repealed for that year only. So if you plan on dying, and your estate is large enough, perhaps that should be the year you do it. Unfortunately, the estate tax in that year is replaced by a capital gains tax on appreciated property you own at death, along with some other punishing tax changes that ease the pain of losing the amount of revenue the estate tax generated.

If you die after December 31, 2010 the federal estate tax returns to the same level as in the year 2002, i.e., the exclusion will be fixed at $1 million. The House and the Senate are in debate about whether to eliminate the tax entirely (unlikely) or to raise the exclusion to around $4 million on a permanent basis (more likely).

If you would like to estimate what your potential tax liability could be, you can go to this site and enter in your assets and debts, and it will calculate the potential tax you would have based on those assets and liabilities.

Having a good estate plan means knowing whether you could be subject to the federal estate tax and how to pay as little tax as possible through having the proper types of Wills and other documents. Don't penalize your future beneficiaries because you didn't adequately plan for their protection from unnecessary taxes.