Even when the tax rules change again
Even though taxes are said to be one of the two certain things in life, there is much about them that is uncertain. And this year, estate planning is especially tricky because of tremendous uncertainty over the new rules that determine how much tax your estate and your heirs would pay in 2010, 2011 and beyond.
Solution: Build flexibility into your will and other elements of your estate plan so that you don’t have to redo them over and over to adjust for changes in the law… the size and makeup of your estate… the size and makeup of your family… and your family’s financial needs.
Without this flexibility, the wrong strategies or even the wrong wording could cost your heirs many thousands — or possibly even millions — of dollars. Also, paying an attorney to make frequent adjustments to an estate plan can get expensive. And people often neglect to make intended changes.
NEW RULES MAY CHANGE
This year’s uncertainty centers on the new estate tax rules that automatically took effect at the beginning of 2010 as the result of federal legislation passed in 2001 — and different rules scheduled to take effect next year. As the law stands now, the federal estate tax disappeared this year but comes back next year, when the portion of an estate above $1 million will be taxed at an overall rate of up to 55%. Also this year, when inherited assets such as stocks and real estate are sold, heirs may have to pay capital gains tax on the entire amount that the assets have gained in value over the years.
Under the old rules, gains from the sale of inherited assets would be computed using the value of those assets at the time that they are inherited as the “stepped-up” tax basis, which could save heirs from paying a great deal of tax. All of the new rules could change drastically if Congress passes new legislation, which could happen this year.
Your estate plan may lack flexibility if it was last updated more than two years ago or was drafted by someone, even an attorney, who does not specialize in estate planning… or if you created your own estate plan using a software program or kit.
FOUR STRATEGIES
To increase the odds of your estate plan being flexible…
The best way to prepare for all this uncertainty if you are married is to retitle your most highly appreciated assets so that potential capital gains are divided more or less evenly between spouses or co-owners. Each estate receives an exemption of $1.3 million from capital gains taxes. By dividing the appreciated assets, you can double your total exemption amount to at least $2.6 million.
Meanwhile, give your executor the power to divide assets among heirs based on the after-tax value and not the pretax appraised value. Otherwise an heir who receives highly appreciated assets might be left with a much smaller after-tax inheritance than one who received less appreciated assets — even though your goal was to make these inheritances equal.
Trouble is, the wording used in wills to transfer assets into these trusts often is so inflexible that changes in estate tax law can have unintended consequences.
Example: Wills often say that whatever amount is exempt from the federal estate tax should be put in a credit shelter trust or pass directly to a descendant, with the remainder of the estate passing to the surviving spouse.
But as of the start of 2010, there is no estate tax. That means the amount exempt from the estate tax is unlimited. If you die before the estate tax is restored, such a will would transfer all your assets to your trust, accidentally disinheriting your spouse (although your spouse might be able to legally challenge such a will). Don’t assume that this problem is solved if the estate tax is reinstated. The new estate tax exemption could be $3.5 million — large enough to absorb all but the biggest estates entirely. This, too, would leave your spouse disinherited.
If your estate plan includes a credit shelter trust, ask your attorney to confirm that the formula used to fund this trust in your will is flexible enough to account for a wide array of possible future changes to the estate tax exemption. A flexible formula might state that your credit shelter trust will receive the lesser of the federal estate tax exemption amount or some predetermined amount (expressed either as a dollar amount or a percentage of your estate).
Example 1: A woman’s will leaves $200,000 to her favorite charity, with the “remainder” of her estate divided among her children. The will was last updated five years ago, before investment losses reduced the overall value of her estate from $500,000 to $200,000. If she dies before her portfolio rebounds, the charity receives her entire estate and her children get nothing, though that was not what she intended.
Example 2: A man wishes to divide his estate evenly between his two children but leave his home entirely to his daughter. The home is worth $400,000 when his estate plan is drafted, so his will gives $400,000 in cash to his son and the home to his daughter, then evenly divides the remainder of the estate. If the value of the man’s home fell dramatically in the recent real estate slump, his daughter will receive much less than her brother, though this was not her father’s intention.
Ask your attorney to remove specific bequests of items of significant value from your will (bequests of items that mainly have sentimental value are not a problem)… or to rewrite these bequests with the caveat that they are not to exceed a predetermined percentage of your overall estate value, with a contingency plan if they do.
Example: “I hereby bequeath to Harvard University the lesser of $100,000 or 5% of the total value of my estate.”
