Is Estate Planning Still Necessary?

Congress continues to debate the future of the estate tax. Over the past several years, both the House and the Senate have proposed scenarios in which the estate tax is reduced or repealed; however, Washington lawmakers are unable to come to an agreement on the issue. In spite of this uncertainty, it is important for individuals to understand how the potential changes may affect their estate planning, so that they are ready to respond once Congress passes new legislation.

The estate tax is generally paid by the wealthiest Americans. The tax can, however, also hit families with smaller assets, especially if they fail to plan for a possible estate tax liability. If the combined value of all of your property—including real estate, investments, insurance policies, savings, pensions, and even personal belongings—exceeds the estate tax exemption amount, your family members may have to pay both federal and state taxes on the inheritance.

Under current law, the estate tax exemption becomes progressively generous in the run-up to 2010, when it phases out completely for a single year. For tax year 2009, the federal estate tax exemption for an individual is set at $3.5 million, and the estate tax rate is 45% in 2009. If no new law is enacted, the estate tax will be repealed for one year only in 2010, and in 2011, it will automatically revert to pre-2002 levels: The estate tax exemption will fall to $1 million, and the estate tax rate will rise to 55%.

With the fate of the estate tax in limbo, how should you plan? While it may be impossible to predict whether, or to what extent, your estate will be subject to taxation at your death, creating and maintaining an estate plan provides essential legal and financial protection for your heirs. If you fail to leave behind a well-structured plan for the distribution of your assets, disagreements between family members may arise, and your estate could end up in probate court.

You can reduce the size of your estate by giving away some of your assets to family members during your lifetime. Gifting is especially beneficial from a tax perspective when income is shifted to a recipient in a lower tax bracket. The annual gift tax exclusion allows a donor to give away up to $13,000 (subject to inflation indexing) per calendar year, per recipient, without incurring a gift tax liability. If you are married and your spouse consents to “splitting” the gift, the annual gift tax exclusion increases to $26,000, even if only one spouse actually makes the entire gift. No gift tax is paid out of pocket until taxable gifts exceed the lifetime gift exemption, currently set at $1 million.

Trusts are also valuable tools for minimizing taxes and protecting your assets from the potentially expensive probate process. A bypass trust is particularly useful for married couples, who can choose to make children or grandchildren, rather than each other, the beneficiaries of the estate. In what is commonly referred to as an A/B arrangement, the bypass trust is combined with a marital trust. Used together, these trusts can help minimize estate taxes on transfers to the next generation, while still allowing the surviving spouse to withdraw funds from the trust for reasonable living expenses. To preserve family harmony and avoid future conflicts over inheritances, you may choose to supplement A/B trusts with a qualified terminable interest property (QTIP) trust, which gives you greater control over the distribution of your assets after your death.

The irrevocable life insurance trust (ILIT) is also frequently recommended as a means of shielding a life insurance policy from federal taxes. When properly implemented, the proceeds of an ILIT will not be included in your estate and will, therefore, be paid out to the trust’s beneficiaries without incurring any estate tax consequences. The trust may be used to finance your children’s education or to provide a staggered income for your heirs.

Clearly, these trusts do more than simply protect your family’s assets from taxation. By planning your estate, you can resolve potential inheritance disputes prior to your death. If the estate tax is permanently eliminated in the future, new estate planning strategies will be necessary. Your heirs may become liable to pay capital gains taxes under new “carryover basis” rules, which are due to go into effect in 2010 and will likely remain in force if the estate tax is repealed. Under carryover rules, inherited property receives a basis equal to the amount the deceased originally paid for the item. Depending on how much the property rose in value between the time of purchase by the deceased and the time of sale by the heir, the recipient of the property could owe much more in capital gains taxes under the carryover basis provision than under step-up basis rules.

In 2010, carryover basis applies to assets above $3 million inherited by the spouse of the deceased, and assets of more than $1.3 million inherited by anyone other than the spouse. Inheritances below these limits are subject to the step-up basis rules. Following the expiration of EGTRRA provisions on December 31, 2010, the step-up basis is scheduled to go back into effect.

Unresolved questions about the future of estate tax rates, exemptions, and the tax basis of assets make estate planning very challenging. Because it is impossible to predict what laws will be in force at the time of death, it is important to prepare for a number of different scenarios. Regular consultations with your tax and legal professionals can help ensure your estate planning decisions remain consistent with your financial and personal objectives, even as tax laws change.