Friday, April 27, 2007

Dealing With the Estate

If you thought the so-called federal “death tax” is dying, you’re wrong. It may slowly vanish over the next few years, but without Congressional action, the estate tax will spring back to full force in 2011.

Here's what’s happening with the federal estate tax: Over the next eight years, the estate tax will be gradually reduced, both by cutting the tax rate and by increasing the exemption levels. In 2002, the estate tax rate dropped from 55 to 50 percent. The tax also only applied to estates of a million dollars or more.

The estate tax rate will be reduced by 1 percent per year until it reaches 45 percent in 2007. Meanwhile, the exemption levels will also increase — to $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009.

In 2010, the estate tax will be completely repealed, but heirs will be subject to capital gains taxes on any of their inheritance that they sell. Furthermore, according to Joel Friedman, a senior fellow at the Center on Budget and Policy Priorities — a Washington, D.C., think tank — capital assets, such as property, stocks, and bonds, are currently assessed the capital gains tax only on value gained after the assets are inherited. Under the new system, the tax would be based on the value gained since the original purchase.

Under the old tax rules, if your father bought a stock for $10 and you inherited it when it was worth $100, and sold it at $150, you'd pay capital gains taxes on the $50 rise in value while you owned it, says Friedman.

It wouldn't matter to the taxman how much your father had paid for it, all that would be important was how much it had gone up since you owned it. "However, under the new system you would have to pay capital gains on the total $140 the stock had gained," says Friedman.
According to Friedman, this new law has the potential to make estate planning and record keeping even more complicated.

Further muddying the waters is an exemption clause in the tax legislation. According to Morgan Stanley Dean Witter, this change in the capital gains tax will be partially offset by an exemption of up to $1.3 million per individual, with an additional $3 million exemption for transfers to a spouse. Assets that qualify for these exemptions would have their base value for tax purposes "stepped up" to the value at the time of inheritance, as under the current system.

So what's the good news?

Even if it does return, the estate tax won't be as strong as it was. The estate tax now doesn’t kick in on assets worth less than $1 million. While that exemption will rise in the following years, it drops back to $1 million in 2011. The drop in the estate tax rate, however, will disappear completely in 2011, and inheritance will be once again taxed at 55 percent.\

The problem is that if the "death tax" stays dead, it will make estate planning much more difficult, according to Dennis Fitzpatrick, a director of advance planning for Northwestern Mutual Insurance Co.

"It's essentially a 'full employment act' for financial advisors," says Fitzpatrick. "This new law makes the tax code so complicated that there's no way an individual can understand it."
In a report co-authored by Friedman for the Center on Budget and Policy Priorities, an argument is made for a permanent and simplified solution to estate taxes. “Retaining the estate tax with a high exemption level and lower top rate, would likely be a more effective way to stabilize long-term planning, not only because it is a more affordable policy in the long run and thus is less likely to be altered in subsequent years, but also because repeal raises serious administrative issues.”

So what does this mean to you?

It's really too early to tell. If you're wondering whether you've wasted money on a survivorship, or "second-to-die," life insurance policy that you bought to pay estate taxes, you probably haven't. According to Fitzpatrick, flexibility in your financial planning is going to be the key for the next decade.

"Because of the complexity of the law, the keys to estate planning are going to be flexibility and control," says Fitzpatrick. "By and large, life insurance is a very flexible product."

Not only are there still estate taxes at the state level to consider, but depending on which year you die, the laws at that time, and the value of your estate, your beneficiaries may need the life insurance benefit. In these cases, according to Fitzpatrick, it's safest to keep the life insurance policy as an added safety net.

Furthermore, a benefit is still a benefit, so even if your beneficiaries don't need the survivorship policy to pay estate taxes, the death benefit still goes to them.

"If you've bought a policy recently, the worst you've done is get some death benefits you may not have needed," says Fitzpatrick.

At the same time, consider whether a new survivorship life policy is the right product for you at this time. Survivorship life policies tend to be cheaper and more easily obtained than traditional life insurance policies, and large estates will almost certainly still end up paying some taxes, but you may want to hold off on a new policy until the future of estate laws is more certain.

According to Fitzpatrick, precise planning will be crucial. With the laws changing every year, and the uncertainty about what will happen in 2011, if you have a large or complicated estate, you may need to revise your estate planning every year, he says.



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