The 2001 Tax Act and Your Estate Plan

While the 2001 Tax Act does reduce estate taxes -- and eventually eliminate them, albeit for a single year -- it would be a mistake to assume you no longer need estate planning. In fact, the Act’s provisions make reviewing and updating your estate plan more important than before.

Although interpretation of the Act will continue for months, perhaps years, Insight addresses some of the questions readers may have about the effect of the new tax structure on their estate plans.

This information is provided by Mark Weinberg, Esq., a prominent Washington-based estate planning attorney. Mr. Weinberg and Christina Mesires Fournaris, Esq., another estate planning attorney, are available to answer questions for National Academies members through the Ask An Expert feature on this site.

Q: Are estate taxes repealed or simply reduced?
A: Both. The 2001 Tax Act gradually reduces estate taxes until complete repeal occurs in the year 2010, for that year only.

Beginning in 2002, the estate tax burden will be reduced in two ways: First, the highest rates will be gradually reduced from the current maximum rate of 55% to 45% by 2009. Second, the unified credit exemption -- the amount you may transfer to beneficiaries other than your spouse -- will gradually increase from $675,000 to $3.5 million. (See this chart for details.)

Q: Could these changes affect how my assets are distributed to my heirs?
A: Possibly. Wills frequently include distribution formulas based upon the estate-tax free exemption amount. Because that amount will nearly triple in just five years’ time, those formulas may produce results you never intended.

Example: Joe’s estate is worth approximately $2 million. To maximize the amount his heirs will receive tax free, Joe’s will stipulates that upon his death, his two children, Bridget and Frank, split an amount equal to the unified credit exemption, with the remainder of his estate going to his wife Holly.

If Joe were to die in 2002, when the exemption is $1 million, Bridget and Frank would each receive $500,000, and Holly would receive the remaining $1 million.

If, however, Joe were to die in 2006, when the exemption is $2 million, Bridget and Frank would each receive $1 million, leaving Holly with nothing.

Additionally, smaller taxes mean a larger amount of money for you to leave to your beneficiaries. This may change not just how you reach your estate planning goals, but your goals themselves.

Example: Neil and Peggy have approximately $6 million in assets. Using a combination of strategies to reduce their estate taxes, their current plan provides $2 million for each of their two children, $1 million to endow a chair at their alma mater, and $1 million to taxes.

With no estate tax, Neil and Peggy have the freedom to decide how that $1 million should be distributed. Though they could give more to their children, Neil and Peggy decide that their children do not need more than the $2 million already provided for each of them. They also consider increasing their gift to the university, but instead decide to split the remaining $1 million between two additional charities they previously could not afford to support in such a substantial way.

Q: Will gift taxes be repealed in 2010?
A: No. The tax on lifetime transfers of assets to family and friends will remain, but like the estate tax, rates will be reduced and the exemption raised.

The $10,000 annual exclusion will also remain in effect. This exclusion allows you to give $10,000 each year to as many individuals as you wish without incurring any gift taxes, or counting toward your exemption amount.

In 2002, the amount exempted from gift tax will increase from $675,000 to $1 million, but unlike the estate tax exemption, this exemption is not scheduled to increase further. Gift tax rates will be reduced from the current maximum rate of 55% to 45% in 2009, following the same schedule as the estate tax rates. In 2010, the gift tax rate will be the same as the highest individual tax rate, currently scheduled at 35%. (See this chart for details on the rate changes.)

Example: Each year, beginning in 2002, Gary makes outright gifts (not in trust) of $110,000 to Steve and Terrence, his two sons. The first $10,000 of each gift is free from gift taxes. The remaining $100,000 of each gift counts towards Gary’s $1 million gift tax exemption. In 2007, the first $10,000 of each gift will still be excluded from gift taxes, but, because Gary will have used up his $1 million exemption (5 years x 2 gifts x $100,000 = $1 million), the remaining $100,000 of each gift will be subject to gift taxes.

Q: Should these changes affect my lifetime gifts to friends and family?
A: Possibly. While you may wish to give up to the $1 million maximum allowable amount, it may be best to stop there and consider other ways to distribute your assets. If the estate tax repeal becomes permanent, you will be better off transferring any additional assets at death, when the transfer will be tax-free.

However, if you do wish to give over the $1 million limit, structuring the gift as part of a charitable donation, such as a charitable lead trust, may help lower your tax bill and provide help to a worthy cause.

Q: How may the changes to the “cost basis” of certain property affect my estate?
A: For income tax purposes, “basis” means the purchase price of property. If you own property and then sell it, the difference between the cost basis and your selling price is your “gain.” This gain is subject to income tax.

Until 2010, those who inherit property are entitled to a “step up” in basis: their income taxes on the eventual sale of inherited property are calculated based on the fair market value of the property on the date of death of the person making the bequest -- rather than that person’s original cost. When the inherited property is eventually sold, this step up in basis effectively reduces or eliminates the income tax on the sale.

However, in 2010, the step up in basis is replaced by a “carryover” basis: the beneficiary inherits the original basis in the property. This provision may result in significant tax on the sale of inherited property with two important exceptions:

(1) For each estate, an increase in the basis of property by $1.3 million is permitted;

(2) For transfers to spouses, a $3 million increase (in addition to the primary $1.3 million) is permitted.

Example: Dave owns stock and a home, each worth $4.5 million. He paid $1 million for the stock, and $1.5 million for the home. Dave wishes to split these assets between his wife Jenny and daughter Rachel so he leaves the home to Jenny and the stock to Rachel. The $3 million exemption for transfers to a spouse raises Jenny’s basis in the home from $1.5 million to $4.5 million. The $1.3 million exemption increases Rachel’s basis in the stock from $1 million to $2.3 million. If Rachel were to sell the stock immediately, she would have a taxable gain of $2.2 million, offsetting some of the savings realized from the repeal of the estate tax.

Q: How might I minimize the taxable gain my heirs might encounter?
A: It is best to leave assets that are subject to the most gain to your spouse first, to take advantage of the additional $3 million basis increase allowed when transferring property to spouses. Additionally, you can help avoid taxes by structuring a charitable gift. Gifts to charity made during your lifetime can provide substantial benefits to you and your heirs, including a healthy income stream, immediate tax savings, avoiding or delaying capital gains taxes, and the ability to shield assets from the claims of creditors.

Q: When the estate tax is repealed, will heirs face other taxes on inheritances?
A: Remember, repeal is only in effect for 2010, and the 2001 Tax Act applies only to federal tax rates; some states have their own estate tax requirements. In addition, assets like individual retirement accounts are still subject to deferred income taxes. Taxes are payable on these accounts at the time of use or transfer at inheritance -- although with proper planning these taxes can be deferred for many years.

Q: How can I reduce the effect of taxes on the retirement plan assets in my estate?
A: If you are already planning a bequest to charity, use your retirement plan residue to do it. Your heirs will still receive the benefit of your charitable donation as a deduction against their inherited amount, and, because the retirement account funds are going to charity, the deferred income taxes are eliminated.

Similarly, funding a testamentary charitable gift annuity or charitable remainder trust with retirement plan residue rather than cash or property will also reduce your heirs’ tax bill.

Q: What happens after 2010?
A: The Tax Act includes a “Sunset Provision” -- in 2011 the tax rates and exemption amounts will revert back to the rules in place before the Tax Act. While Congress is expected to take action to prevent this, it’s impossible to say definitively what the tax laws will be like in 2011. As long as this uncertainty remains, it is virtually impossible to be sure your estate plan will work as originally planned after 2010.This does not mean you should avoid estate planning for the next ten years; beginning to plan and establishing goals now will make it easier to adapt your plan to future changes in tax law.

Q: Anything else I should know?
A: There is much more to the 2001 Tax Act than what we’ve covered here. You can find more information about the Tax Act and estate planning in general on the Insight on Estate Planning and Estate Planning News index pages.

As always, though, the best advice is to review your current plan with your professional advisors to determine how the new tax legislation may affect your individual estate plan goals and objectives.

For more information, contact the National Academies Estate-based Philanthropy Program at giving@nationalacademies.org or 202-334-2431.