Under current law, any assets in a deceased person’s estate over and above $5 million are subject to a 35 percent tax. Surviving spouses receive an unlimited exemption. Assets held in one spouse’s name pass freely and directly to the surviving spouse without any tax liability at the federal level. The IRS just bides its time and taxes the estate at the death of the second spouse.
Unless Congress intervenes, though, the amount exempted from estate tax and the percentage charged on amounts over the exemption threshold is changing at the end of the year – for the worse.
Specifically, the exemption threshold falls – to just $1 million.
This means that potentially millions of families who thought they were never going to be subject to the estate tax are going to get a nasty surprise after the death of a loved one. There’s no exemption for the value of a home or balances in 401(k)s and IRAs. The new threshold will through many middle class individuals into estate tax territory. According to the Tax Policy Center, that threshold will cause a tax to be levied on some 53,000 estates nationwide beginning in 2013. More as home values recover.
Additionally, the top estate tax bracket increases from 35 percent to 55 percent. The IRS will take over half of everything you’ve worked for all your life before you pass it on to your children.
An additional 5 percent surtax will apply to very large estates.
Neither of the 2012 presidential candidates is too happy with the new levels. Mitt Romney has proposed repealing the estate tax altogether, while Barack Obama is pushing to reset the estate tax to 2009 levels: A $3.5 million exemption and a 45 percent top estate tax rate.
The estate tax poses a particular problem for families whose estates are illiquid. For example, the family legacy may be largely in the form of a family home, other real estate, or a closely-held small business. It’s tough to sell these kinds of assets on short notice to raise the cash needed to pay the estate tax. Families are frequently forced to unload assets financially at fire sale prices to raise the cash – if they can be sold at all.
To minimize the impact of estate taxes, here are some steps you can take:
Begin to implement a planned giving strategy, moving assets out of your taxable estate into the hands of your family members who will eventually inherit them anyway. Under current law, you can gift up to $13,000 per year each to as many people as you like without an estate tax consequence – subject to a lifetime limit. If you are married, you and your spouse can “double up” gifts, up to $26,000 per recipient – again without a tax consequence.
Consider permanent life insurance. A permanent policy – whole life or universal life – can provide the cash your family needs just when they need it to pay the estate tax. This is an excellent application for permanent life insurance, because it prevents surviving family members from having to quickly sell off illiquid assets at a discount.
Some companies will finance premiums using real estate or other assets as collateral – which allows families to buy the permanent policies they need without putting them in a cash flow crunch.
Draft a Trust.
Assets held in irrevocable trusts are not a taxable part of your estate. However, there may be gift taxes on some large transfers to trusts or other entities. One particularly common technique for married couples is the A-B trust. This kind of trust helps lower the overall estate tax bill of a married couple by maximizing each spouse’s exemption allowance. When one spouse dies, assets are placed in an irrevocable trust for the benefit of the surviving spouse. The assets are removed from the surviving spouse’s taxable estate. If you make the estate a beneficiary of a life insurance policy, rather than naming your spouse directly, you may be able to avoid a hefty estate tax exposure.
If one or both spouses is a foreign national, you cannot rely on the benefit of the full exemption for the surviving spouse. Congress was concerned about widows and widowers taking their wealth back home after a spouse’s death to avoid the U.S. estate tax.