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ESTATE PLANNING
The New Estate-Tax Rules

The federal estate tax is scheduled to ride into the sunset by decade's end. But its ultimate fate is unclear: Like a movie that leaves the door open for a sequel, it's possible that the estate tax might return.

Under the legislation signed by President Bush in June 2001, the federal estate tax will be gradually phased out. The law replaced the $675,000 unified gift- and estate-tax credit with a $1 million unified exemption -- the amount that each individual can pass free of federal estate tax. The exemption climbs to $3.5 million in 2009. The estate tax disappears completely in 2010 (see the table below).

The law also snipped the top estate-tax rate from 55% to 50% in 2002 and whittles the rate to 45% in 2009.

Each person also gets a lifetime gift exemption of $1 million. Taxable gifts -- those more than the $10,000 annual exclusion -- count against that limit. In 2010, when the estate tax is gone, the gift tax remains. Its top rate will be 35%.

In 2011, if lawmakers do nothing, the federal estate tax returns to 55% and estates of $1 million or more would again be taxed at the top rate. The way it's written, "the repeal is really a suspension of the tax for one year," says Mark West of the Principal Financial Group, in Des Moines, which specializes in retirement and financial services.

Expect Congress and future administrations to tinker with the law. If anticipated budget surpluses don't materialize on schedule or fall short, more change is certain. For planning purposes, you can assume

Congress will keep a large exemption. Neither outright repeal nor return to the present tax rates will fly.

Increased exclusion amount may not measure up

Despite the increases in the exemption amount, if your estate is at the taxable level, don't expect huge tax savings. For example, suppose you had a $10-million estate that grows 4% annually: If you had died before the tax law, you would have owed about $4.9 million in estate taxes, says West. If you survive until 2008 and the law remains the same, your estate would be $13.2 million and your estate-tax bill would still hover around $4.9 million. If you died the following year (when the exemption is $3.5 million), the bill would drop to $4.6 million. If you lived until 2010, your estate would pass tax-free. On the other hand, if you celebrate New Year's 2011 and then die leaving an estate of $14.8 million, Uncle Sam's share could approach $7.6 million.

The step-up takes a step down

The step-up in basis on inherited property will vanish in 2010. Currently, assets left to heirs generally receive a step-up in basis to the full market value on the date of your death. When your heirs sell inherited property, such as stocks or real estate, they owe capital gains only on the difference between the stepped-up value and the selling price. Let's say you leave stocks to your daughter. If you paid $100,000 for them and they're worth $500,000 when you die, she would receive a step-up in basis to $500,000. If she later sells the stock for $1 million, her tax will be based on a $500,000 gain.

Under the new law, there is a cap on the step-up your heir receives. When he or she sells the asset, the capital gain will be based on the difference between the selling price and what you originally paid for the assets (your tax basis) plus the allowed step-up.

How much is allowed depends on who your heir is. Heirs who are not spouses can add $1.3 million to their tax basis. Surviving spouses add an additional $3 million, for a total of $4.3 million plus the tax basis. Although most heirs won't owe capital-gains tax on inherited property when they sell, it could happen.

Adjustments to the gift tax

The top rate on taxable gifts drops in tandem with the estate-tax rates until 2010. That's when the estate tax disappears and the top gift-tax rate settles in at 35% -- the same as the highest income-tax rate. Lawmakers kept this tax to stymie lifetime transfers of income-producing property to heirs in a lower income-tax bracket to reduce income taxes.

There's no change in the annual exclusion, so you can still make annual gifts of up to $10,000 to as many people as you wish without triggering the tax.

The generation-skipping transfer tax, which is pegged to the highest estate-tax rate, is scheduled for gradual phaseout and repeal in 2010. It applies to transfers of property made to someone more than a generation younger than the giver, such as a grandchild.

What should you do?

Assume that the estate tax won't entirely disappear, says Bill Wolfkiel, an estate planner with the American Wealth Transfer Group, in Louisville, Colo.

In addition, resign yourself to paying your lawyer more and spending more time in consultation, because the new rules are complex and likely to change. Stay focused on the primary reasons for planning in the first place: to provide for your heirs and make sure that your assets will be distributed as you wish.

Andrew Hook, an elder-law lawyer in Portsmouth, Va., suggests reexamining several issues in light of the tax changes. For example, if you use formulas to determine how much you should set aside to use as gifts or to take advantage of marital deductions and the unified gift- and estate-tax credit, have your lawyer recalculate the numbers under the new rules. And if your estate is currently more than $1 million, he suggests that you consider having your will and trusts reviewed. Depending on your situation and the size of your estate, you may want to have them redrafted to take the new rules into account. Married couples may want to look into using disclaimers as a way to give a surviving spouse the power to create estate-tax-saving trusts.

Arm Yourself With Solid Information

The following resources can throw additional light on the new (and ever-shifting) estate-tax rules:

• Estate Planning Under the New Law: What You Need to Know ($7 plus shipping).



• RIA's Complete Analysis of the Economic Growth and Tax Relief Reconciliation Act of 2001 ($44.95, 800-950-1216) contains helpful advice and illustrations.

Planning Under the New Rules