In Taxing Planning 2011-12, anyone who has been to visit a financial planner or estate planning attorney this past year probably knows that the federal estate and generation-skipping transfer (GST) taxes were repealed for 2010. Even if you haven’t visited an attorney to discuss your will or estate plan, you’ve likely heard a joke about how 2010 was a “great year to die.” But as the year draws to a close, so does the repealed tax.
So, the question is, what is next for the federal estate tax?
If Congress hadn’t acted in December, the estate and GST taxes would have been reinstated at their 2001 levels, which allowed for the first $1 million of a person’s estate to pass on tax-free, and the remaining to be taxed up to a rate of 55 percent.
Overview of the 2010 Tax Relief Act: 2011-2012 Rules
On December 17, 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the 2010 Tax Relief Act) was enacted, changing the way federal estate, GST and gift taxes will be handled for 2011 and 2012. But before you get excited, remember that the new law expires at the end of 2012, when the 2001 tax levels are automatically reinstated. While 2010 may have been a great year to die, and 2011 and 2012 aren’t bad either, watch out for 2013!
Here is what the law does for the next two years:
- Federal Estate Tax. Estates of the deceased receive a $5 million exemption per person, which means that the first $5 million of an individual’s estate passes on tax-free. The estate tax rate is 35 percent.
- Gift Tax. The exclusion amount for gifts is unified with the $5 million estate tax exemption, which means that an individual can gift up to $5 million the next two years without paying taxes on it. But if that individual were also to die in the next two years after giving away $5 million in lifetime gifts, then his entire estate would be taxed. If the individual were to die after giving away $4 million in lifetime gifts, then $1 million of his estate would be tax-free, utilizing the remainder of his $5 million exemption. The tax rate for any lifetime gifts given over $5 million is 35 percent.
- Generation Skipping Transfer (GST) Tax. The GST tax is designed to prevent wealthy individuals from simply giving their grandchildren assets outright in order to avoid paying estate taxes when their children die (i.e., skipping a generation of estate taxes). Like the exemption for estate and gift taxes, there is also an exemption for GST tax which allows donors to pass a limited amount of assets free of GST tax to qualified younger generations. Similar to the federal estate tax, the exclusion for any generation skipping transfers in 2011 and 2012 is limited to $5 million per person. The tax rate for transfers in excess of that is 35 percent.
The New Federal Estate and Gift Taxes’ Implications for Couples
One of the major changes allowed under the Tax Relief Act provides a tax benefit for widowed individuals whose spouse dies in 2011 or 2012.
Without proper tax planning, what typically happens when one spouse dies is that the entire estate is passed on to the other spouse tax-free, without applying the first spouse’s exemption. The problem ensues when the second spouse dies, because anything above the second spouse’s exemption amount is taxed. Essentially, the first spouse’s exemption is lost. For example, Harry dies leaving his estate to his wife, Wendy. Wendy gets everything without paying taxes, but when she dies only the first $5 million (or applicable exemption rate at the time of death) would pass tax-free.
Bypass, or family trusts, helped work around this and allowed for exemptions for both spouses to be utilized.
What this means is that for the next two years, bypass trusts are no longer needed to be able to use both spouses’ federal exemptions. Starting in 2011, widows and widowers can add any unused estate tax exemption of their recently deceased spouse to their own – allowing up to $10 million to be transferred tax free.
Under the new law, Harry dies leaving his estate to Wendy. Wendy still gets everything without paying taxes, and now when she dies her $5 million exemption plus Harry’s previously unused $5 million exemption allows Wendy’s estate to pass $10 million to her heirs without being taxed.
This portability of exemption also applies to the gift tax since it is unified with the estate tax, meaning that Wendy could use part of Harry’s unused $5 million exemption to give tax-free lifetime gifts if she so chose.
Importance of Continued Estate and Tax Planning
This may sounds like good news, but be careful. Remember, this provision only applies if you are your spouse die in the next two years. Also, there are many non-tax reasons to create a bypass trust. For example, with a bypass trust you can protect the deceased spouse’s assets from being spent down so the surviving spouse can qualify for long-term care assistance. The bypass trust assets can also be protected from the surviving spouse’s creditors, or from the new spouse if the surviving spouse remarries.
In addition, twenty-one states and the District of Columbia have their own estate or inheritance taxes. For many of those states, only the first $1 million or less is exempt from taxes, so it is still important to utilize bypass or family trusts to reduce the amount of state death taxes paid.
Arizona does not currently have a state death or estate tax, but Arizona residents may still own real estate in another state that would be subject to a state death tax, so proper tax planning is important to preserve their assets.
These new laws are only in place until December 31, 2012, so discussions of estate tax will be renewed as 2013 approaches. Given the ever-changing nature of the federal tax laws, it is important to consult with an estate planning attorney to make sure your estate plan is up to date and you are taking advantage of all the law has to offer.