Estate Planning for 2006 and Beyond

If you are concerned about taking care of your loved ones and protecting what you have worked so hard to build, free your mind of a major worry by getting your federal estate plan in order this month.  There’s no time like the present to do it.

First, you need to think about your assets and your plan.  The rules keep changing and will continue to change over the next several years.  Think of estate planning for this year and the next several years like visits to the dentist: necessary, uncomfortable, but definitely worthwhile.

Do You Need an Estate Plan?

Your government is making the federal estate tax more and more taxpayer-friendly.  This cuddling-up process started on January 1, 2002, when the federal estate tax exemption jumped from $700,000 to $1 million.  On January 1, 2004, the amount exempt from the estate tax jumped from $1 million to $1.5 million.  State 3 of this estate tax love-in took place on the first of this month—January 1, 2006—when the estate tax exemption jumped to $2 million.

For federal estate tax purposes, you do not need an estate plan

• If you are single and your estate is less than $2 million, or
• If you are married and both you and your spouse have individual estates of less than $2 million.

You need a plan if either you or your spouse has an estate valued at more than $2 million.  The estate value includes everything you own at the time of your death: life insurance, retirement plans, homes, businesses, investments, jewelry, silverware, and furniture.  If what you own has value, it is part of your taxable estate.

Even if you do not need an estate plan, you may need a probate or other plan.  This article focuses specifically on the federal estate plan.

Married with Joint Estate Over $2 Million

If you are married, your first priority is to make sure that both you and your spouse realize individually the full benefits of the $2 million exclusion to which you are entitled as U.S. citizens.  That’s where the plan comes in.

For example, say your estate is worth $3 million and your spouse’s estate is worth $300,000.  With no plan, your estate will pay $460,000 in taxes (46% on the $1 million in excess of the $2 million exclusion).

A good will or living trust document will have bypass trust language built into it.  The language built into it.  The language will transfer $1 million of your taxable estate to your spouse.  As a result of this planning, your estates now stand at

• $2 million for you, and
• $1.3 million for your spouse.

Since the exemption is $2 million, neither you nor your spouse will have an estate that has to pay taxes.  Thus, the difference between a plan and no plan is $460,000 in taxes.  Do we have your attention?

In general, using the facts from this example, your plan starts with the bypass language in your will or living trust.  This bypass language stipulates that, upon your death, $2 million of your estate is going into a bypass trust that

• names your children as the ultimate trust beneficiaries, and
• provides reasonable living expenses for your spouse.

The bypass trust takes effect upon your death.  The $2 million is included in your estate because you named the ultimate beneficiaries of this trust.  When your heirs complete the estate tax return, they use the $2 million exclusion to wipe out every penny of estate tax.

Here’s how your spouse stands:

• Your spouse has use of the $2 million bypass trust for reasonable living expenses.
• Your spouse has his or her original $300,000 in net asset value.
• Your spouse has the $1 million worth of assets that you transferred at your death.

Look at the planning result this way: Before your death, and because of the plan, your spouse has use of close to the same amount until his or her death.  Further, because you had a plan, you kept $460,000 away from the government and in the hands of your heirs.

This is a good plan.  If you have a situation like this one, meet with your tax and financial advisors and put together a good plan.

BEWARE of the Overfunded Bypass Trust Problem

The newly effective (this month) $2 million federal estate tax exemption could have negative financial consequences.  Many bypass trust arrangements automatically fund an amount equal to the current federal estate tax exemption (no specific dollar figure is mentioned).  So, with the exemption jumping to $2 million this year, you might have too much money going into your bypass trust and too little going to your surviving spouse.

Example.  Let’s say you have a $2.3 million estate and your spouse has virtually nothing.  Your current will, written when the federal estate tax exemption was $700,000, stipulates that if you die before your spouse, your bypass trust is to be funded with an amount equal to the current federal estate tax exemption.  If you die right this moment, $2 million automatically goes into the trust, and your spouse gets $300,000.

Problem 1.  The $300,000 might be far less than you intended.

Problem 2.  Using the bypass trust to meet your spouse’s reasonable financial needs can be a dicey business.  Say your children have a disagreement with your surviving spouse about what is “reasonable.”  If you have children from one or more previous marriages, the probability of disagreement increases exponentially.

Even in the best case, your spouse may feel compelled to ask your kids for permission to dip into the bypass trust.  That could create an uncomfortable situation for all.

Solution.  Pick a better number.  Revise your will.  With all the changes to the estate tax, revisit that number every few years.

BEWARE of the Underfunded Bypass Trust Problem

How are you set up now?  Have you designated a specific amount for your bypass trust?  Did you base this amount on an old law?

Example.  Say, upon your death, your bypass trust is set to receive $1 million, with the balance of your estate going to your spouse.  Say further that your estate is worth $5 million and your spouse has a $4 million estate.  If you make no changes in your plan and die this very moment, you will overpay your federal estate taxes by $460,000, because you underfunded your bypass trust by $1 million (remember, today’s magic number is $2 million).

Solution.  Now, because you have been reading this article, you increase your bypass trust from $1 million to $2 million and save your heirs $460,000 in estate taxes.

Planning tip.  You need to plan for estate tax avoidance.  Further, regardless of the plan you set up originally, you need to revisit this plan, because lawmakers keep making changes and will continue to make changes until at lease 2010.  So, for the next four years, plan a review at least every other year.

Unmarried?  You May Be Giving Too Much to Charity

If you are not married, you can ignore the bypass trust concept.  It is designed for married taxpayers.  However, you still need to consider the $2 million exemption.  Are you under or over the $2 million?  Do you have the right amount set up for the $2 million?

For example, say you want to leave just enough to charity to reduce your taxable estate to the magic $2 million figure.  You need a plan.  If you don’t plan, you will make the federal government both your charity and your beneficiary.  Yikes!

Pay Attention!

Wow, how things change!  During the past five years, major changes have taken place in the federal estate tax, and more changes are coming.

The law is only one part of the equation.  Personal situations change, too.  You could win the lottery; your home might skyrocket in value; relatives could die; you might disown or reown relatives, or collect more children or grandchildren.

Changes, which always happen, often render estate plans obsolete.  Make sure your plan does not become obsolete—review it for necessary alterations.

Information provided by Tax Reduction Letter, January 2006, Volume 15, Number 1

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