The Bogleheads' Guide to Retirement Planning (44 page)

Estate planning can be complicated, but it is important to address the topic before the emergency happens. Knowing how property can be owned and how it can be transferred at death is an important step in estate planning. Understanding the legal process of probate provides a reason to avoid it if possible. People should have certain documents in order, including durable powers of attorney, living wills/advance directives, wills, and trusts. Trusts are a great way to direct your assets. There are many different types that are used for different reasons. Buy-sell agreements are a crucial consideration for anyone engaged in his or her own business. Estate planning is comprehensive and should be done with the help of a qualified expert who is familiar with the laws of your state.

“When you’re dead, you’re dead. That’s it.” Well, Marlene Dietrich may not have gotten it exactly right because after death it isn’t over. The government is not done with you yet, or at least not done with your money. Your heirs may be subject to an ominous estate tax, better known as the death tax.

Planning today for sharing your wealth can save your heirs thousands of dollars in the future. This chapter provides an introduction to estate and gift taxes. It provides a basic understanding of how these taxes work and how to mitigate their damage. Increased understanding will help you arrive at an estate plan that best meets your needs. It will also help you administer an estate more effectively if you are appointed to be a personal representative. However, this short chapter does not have all the answers. Your estate plan should involve a qualified estate-planning or tax attorney.

Malcolm Forbes once said, “I made my money the old-fashioned way. I was very nice to a wealthy relative right before he died.” We should all be so lucky. Most Bogleheads will work hard and accumulate assets over a long period. If successful, many people make tax-free gifts to their loved ones to help with college, buying a home, and all sorts of things. At the time of death, these people want to escape government confiscation through taxation and transfer as much wealth as legally possible to their heirs.

Whether you give things away while you are alive or after you die, Uncle Sam wants to spread some of your wealth around. The gift tax is part of the estate tax system and not part of the income tax system. It levies the same tax on transfers that would be assessed after the donor dies and is intended to prevent people from giving everything away while alive and avoiding the estate (a.k.a. inheritance and death) tax.

In 2001, President George W. Bush pledged to get rid of the federal estate tax. He carried through with that pledge to a degree. Congress approved the Economic Growth and Tax Relief Reconciliation Act of 2001 (the 2001 Tax Act), which made substantial changes to the estate and gift tax laws. By 2010, the estate tax would be completely eliminated. Unfortunately, that would be temporary. By 2011, all the changes made by President Bush are to sunset, and federal estate taxes will snap back to their onerous pre-2001 level, and in some cases higher.

The Internal Revenue Code provides a table that tells the levels of taxation based on year. There are two important numbers in
Table 17.1
. The unified credit is a credit against estate taxes that would otherwise be due as the result of death. It is used in the actual computation of the tax in the estate and gift tax return. The second number is the applicable exclusion amount. That tells you how much you can pass on to your heirs free of tax.

Changes to the estate tax unified credit and the resulting applicable exclusion amount were implemented beginning in 2002. In 2006, the unified credit was increased to $780,800, where it remained until the end of 2008. A unified credit of $780,800 effectively means that estates of less than $2 million are not taxed. The credit is available to the estate of each individual person. So for married couples, if each party through good estate planning preserves his or her unified credit, the value of the assets that can pass free of estate tax is doubled to $4 million. In 2009, the unified credit increased to $1,455,800, resulting in individual estates of less than $3.5 million not being taxed or twice that amount, $7 million not being taxed for a couple using widely available estate planning techniques.

Source:
U.S. Internal Revenue Code

As of this writing, in 2010, the credit will drop to 0 percent, essentially repealing the federal estate tax. On January 1, 2011, the estate tax repeal sunsets. The unified credit will return to $345,800 on estates of more than $1 million for a single taxpayer and $2 million for a couple unless Congress acts to extend or modify the exclusion amount.

Estate and gift taxes are constantly being tweaked as Washington plays political football. The 2001 Tax Act changed the effective minimum tax rate, the rate applicable after the application of the unified credit, and the top tax rate of estate and gift tax. After the act was adopted, the effective minimum tax rate was increased by virtue of the increase in the amount of the unified credit, and the top rate was decreased by virtue of the statutory changes contained in the act. For 2008 and 2009, the maximum tax rate is 45 percent. That rate will continue in effect until 2010, when the estate tax rate will be 0 percent.

That said, it is very likely that the estate tax will not go away in 2010, as the subject is up for debate again in Congress. Check with the IRS or an estate-planning attorney before making any financial decisions about gifting.

The generation-skipping transfer tax (GSTT) is a federal tax on transfers of property made to a family member who is more than one generation below the donor; they occur either during life as a gift or at death by will or bequest. The GSTT exemption amount is the same as the estate tax applicable exclusion amount and will continue to be so. The GSTT tax rate continues to be the same as the top estate tax rate during the time period the act is in effect and thereafter. The benefit to a large estate is that the money skips a generation, so it is taxed only every other generation.

With such high estate tax rates, perhaps the better option is to gift your money to your children. Not so fast! Congress keeps that loophole closed by limiting the amount you can gift without paying gift tax.

The gift tax applicable exclusion amount is $1 million in 2008, 2009, and 2010. In 2010, when the estate tax and GSTT are repealed, the gift tax will continue in effect. Presumably, this was done so that gifts made in 2010 would not escape taxation, although the maximum tax rate of 35 percent is lower than the estate tax rate would be in 2009, prior to repeal, or in 2011, after the changes sunset, so it may still be advantageous to make gifts, especially of appreciating property (more on that in a minute).

The donor is generally responsible for paying the gift tax. Under special arrangements, the donee may agree to pay the tax instead. See your tax professional if you are considering this type of arrangement.

Under the law prior to passage of the act, assets acquired from a decedent were entitled to a basis value equal to the fair market value on the date of their death. That rule will change for people dying in 2010. The basis of property acquired from someone who died will be essentially the same as for property acquired by gift, which means it is the amount the decedent paid for it. Prior to 2010, a stock’s basis is the date of death price. During 2010, it is the decedent’s purchase price.

There is some relief from the harshness of this provision in that the law allows the personal representative to allocate $1.3 million of basis to appreciated property, and in the case of a decedent who was married at the time of death, an additional $3 million of basis can be allocated to appreciated property. This provision will apply only to decedents dying in 2010.

After 2010, a single individual will be able to pass $1 million free of tax, and married couples will, by preserving both unified credits, be able to pass twice that amount. The highest tax rate will be 55 percent, except that a 5 percent surtax will once again apply to estates in excess of $10 million. This could all change in the future. Consult your tax adviser or estate-planning attorney before making any major gifts.

This section provides an introduction to the calculation of federal estate taxes. It is calculated by using U.S. Estate (and Generation-Skipping Transfer) Tax Return Form 706, available on
www.irs.gov
.

An estate tax return must be filed once for all citizens or residents of the United States who die with a taxable estate. The term
taxable estate
refers to gross estate less allowable deductions.

Generally, a decedent’s assets are valued as of the date of death. In some cases, the value is interpolated between dates. For example, if a person dies on a weekend, the value of stock can be computed as the average of the close on Friday and the close on Monday. Congress long ago recognized that the value of assets might go into a steep decline immediately after someone died. If that happened, it would be unfair to tax the heirs on the value of the estate at the time of death, when the heirs would not be able to realize value from the estate so quickly. Therefore, the law allows an alternative valuation date that is six months after the date of death.

If an estate declines in value after the death and the alternate valuation date was used, it would serve to reduce the total amount of tax due. Use of the alternate valuation date can sometimes result in substantial tax savings.

All of your property owned at the time of death is included in the gross estate. Items such as securities, real estate, mortgages owned, notes and cash, life insurance, and other miscellaneous property, including personal property and money owed to the decedent, are all included.

The Internal Revenue Code also contains a host of provisions designed to limit gray areas on the part of heirs designed to reduce taxes. These include certain property transferred within three years of death, transfers in which some aspect of ownership was retained or in which you retained a reversionary interest, transfers in which you retained the right to revoke the transfer, annuities in which the purchaser retained a right to receive payments, jointly owned property, property that could pass under a general power of appointment, certain life insurance, and a special category of property known as qualifying terminable interest property.

There are allowable deductions from a taxable gross estate to find the taxable estate. Funeral expenses and expenses incurred in administering property subject to claims (estate administration expenses) can be deducted. Debts including mortgages and liens are deducted. Net losses during estate administration are deducted, as are expenses incurred in administering property not subject to claims. Potentially, this deduction could reduce the estate tax to zero in even the largest estate. Finally, a deduction is allowed for gifts to charities.

Taxable gifts made after December 31, 1976, must be added back into the estate. A credit given for prior gift taxes paid ensures that is the case. Once gifts are added back, a tentative tax can be computed. Any prior gift taxes paid are then deducted from the tentative tax. This statutory scheme is designed so that all gifts are taxed, but only once.

Subtracting previously paid gift taxes from the tentative tax results in a gross estate tax. From here, some credits are potentially available that may serve to further reduce the tax due. The first of these is the unified credit discussed earlier and highlighted in
Table 17.1
. The estate is also allowed a credit for foreign estate taxes paid and a credit for estate taxes paid by a prior estate on the assets inherited. The credits reduce the gross estate tax and yield the estate tax due, assuming there are no generation-skipping transfer taxes (discussed later).

There are some important points you should take away from this discussion. Married couples should engage in estate planning to take advantage of both personal exemption amounts while both are still alive. Also, assets that are not included in the gross estate may avoid taxation completely, such as insurance policies held in a properly constructed irrevocable life insurance trust. Finally, don’t forget that charitable bequests reduce the estate dollar for dollar and can be used to reduce taxes while simultaneously supporting a cause you believe in.