Congress is considering reforming (permanently, this time) the confusing federal estate-tax law. But don't wait for Congress to act before revisiting your personal estate plan. Changes already scheduled to take effect at year-end hasten the need to dust off your family's estate plan later this year, regardless of Congress's actions.
Here's what's happening: Under President Bush's first big tax cut law in 2001, the top federal estate-tax rate was set along a path to decline gradually from 55 to 45 percent in 2009. At the same time, the estate-tax exemption level—the amount of your estate that you can shelter from estate taxes—is rising from $675,000 in 2001 to $3.5 million in 2009. (The 2005 exemption level is $1.5 million, jumping to $2 million next year.)
The federal estate tax is scheduled to disappear completely in 2010. But only for one year. Because of the law's "sunset" provision, estate taxes come roaring back to life in 2011, with top rates again at 55 percent and exemption levels falling back to a measly $1 million.
Congress had promised they'd fix the problem either by extending those better tax rates and exemption levels for future years, or by completely eliminating the federal estate tax.
The House this year actually took the full bite, voting to repeal estate taxes. Now, it's the Senate's turn. But it's less likely to go for full repeal. The Senate may, however, strike a compromise with the House to permanently set a lower estate tax rate and set exemption levels in the $5 million to $10 million range.
In the past few years, uncertainty about estate-tax reforms has left affluent Americans scratching their heads over the best tax-wise ways to manage their estates.
Our advice: Keep an eye on Congress; chances are about 50/50 that it will finally set some estate-tax reforms in stone.
But don't ignore your estate plan. By the end of this year, you may need to adjust your estate plan to reflect the higher exemption level, which rises to $2 million on Jan. 1. Consider these three moves:
1. Avoid overfunding a trust. If you use "bypass trust" language in your will that splits your estate between your spouse and children, the portion that goes to your children is often linked to the estate-tax exemption amount. But if you direct too much money into that trust for the kids, you may shortchange your spouse if you die. In other words, too much money would go into the trust, too little would go directly to your surviving spouse.
Example: Say you had a $2.5 million estate and your will directs an amount equal to the estate-tax exemption into a bypass trust for the kids. That exemption rises to $2 million next year, which means your spouse would receive only $500,000 if you died, which may be less than you intended.
Solution: Revise the trust to reflect a specific dollar figure for your spouse. Don't tie it to the exemption level.
2. Avoid underfunding a trust. You may also run into the opposite problem: Your current estate plan directs too much money to your spouse—more than he or she needs. That could happen if your estate is large and your will designates a specific dollar figure to fund the bypass trust. That means the trust won't be funded with enough money to take full advantage of the new $2 million exemption that takes effect in 2006.
Again, the best solution is to adjust the amount used to fund the bypass trust to at least equal the new $2 million exemption.
3. Keep giving lifetime gifts. There's no harm in continuing a lifetime gift-giving program as long as you don't need all the funds. Besides removing assets from your taxable estate, your family will save income tax if the gift recipients are in lower tax brackets. That's because the subsequent income produced by the gifts will be taxed to them, not you.
Final tip: Estate planning isn't a one-size-fits-all exercise. Huddle with your estate-planning pro to make revisions that make sense for your family.
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