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.

And there’s one additional wrinkle: Unless the rules change, some people who inherit appreciated assets in 2010 will face new capital gains taxes and a paperwork nightmare, even if they escape the estate tax. That’s because when inherited assets are later sold, gains will be figured on the basis of the original owner’s purchase price, with gains above $1.3 million taxed at 15%. Previously, the “cost basis” of inherited assets was the value at the time the previous owner died.

In other words, if grandpa bought Microsoft (Stock Quote: MSFT) at a split-adjusted price of 10 cents a share in the mid-'80s, and you inherit them in 2010 and immediately sell them for $30, you’d owe tax on a $29.90 per-share gain. Under the old rules, there would be no tax if you inherit at $30 a share and sell at $30 a share. The new capital gains rule would apply to all sorts of inherited assets, including the deceased’s home.

So, what can you do to prepare? The most obvious step is to reduce the size of your estate, though that may not be especially appealing. That can be done by giving assets to your heirs before you die. In 2010, any individual can give any other individual up to $13,000 without triggering gift tax. That means a couple could give four grandchildren $104,000 in 2010. Presumably, similar gifts could be made in subsequent years.

Also consider funding a child’s 529 college-savings plan. Special rules allow one person to put up to $65,000 into a 529 in one year, accounting for five years’ worth of $13,000 donations. Money put into a 529 is removed from the giver’s estate but remains under the giver’s control.

Tax attorneys have a variety of tax-cutting tricks, like one spouse setting up a bypass trust that makes money available for the surviving spouse. When the second spouse dies, the trust and that spouse’s assets each qualify for a full estate-tax exemption.

Many people who expect to leave taxable estates buy life insurance to pay the tax. The insurance benefit can be kept out of the estate if the policy is owned by an irrevocable life insurance trust.

Unfortunately, since it’s impossible to know what the rules will be, it may not be wise to make irreversible moves like setting up a trust.

So for now the best policy is probably to watch and wait — to be ready to move quickly when the rules of the game are clearer.

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