Handling the Estate Tax Mess

Well, this is a surprise. And what a mess!

Back in 2001 when Washington revised the estate-tax laws, everyone figured the sunset clause restoring the old rules after 2010 were just a technicality. Surely, lawmakers would set permanent rules long before then.

But they haven’t. So, since Jan. 1, there have been no federal estate taxes. Then, unless Washington acts, on Jan. 1, 2011, the old rules come back, making assets more than $1 million subject to the estate tax of 55%. That’s worse than the rules in 2009, which exempted the first $3.5 million in assets and taxed the rest at 45%.

Going back to the $1 million exemption still means that most people will not leave taxable estates, but it will snag lots of folks who think of themselves as solidly middle class, not rich.

The estate includes not just assets like stocks, bonds and mutual funds, but real estate, including the primary residence, and life insurance benefits. A person with a $400,000 home, $500,000 life insurance policy and $600,000 in investments would leave a $1.5 million estate, with $500,000 subject to tax at the 55% rate in 2011. Fortunately, the tax does not apply to property left to one spouse by the other, but will kick in after the second spouse dies.

The House voted in December to permanently set the rate at 45% for assets more than $3.5 million for individuals and $7 million for couples. But the Senate has not acted.

Some tax pros expect Congress to extend the 2009 rules — $3.5 million exempted and 45% rate after that — for 2010. But even if it does, there could be a legal wrangle over whether that tax can be retroactive to Jan. 1.

That leaves things in limbo.