2010, a Tax Odyssey

2010, a Tax Odyssey

The wild and crazy estate tax law complicates estate planning for the next several years. Here’s a guide for the perplexed.

By Alan G. Orlowsky, J.D., C.P.A.

A version of this article was published in Vital Times, July 2002. Updated in January 2005 and April 2008.

The Economic Growth and Tax Relief Reconciliation Act of 2001 brought us good news and bad news. Here’s the good news: most of us will pay less estate tax. And if you die in 2010, your estate will owe no tax at all. I don´t want to be known as the lawyer who advises clients to die in the year 2010. But if you just happen to be gravely ailing on New Years Eve of 2009, you could potentially save your heirs thousands of dollars by hanging on past midnight. (Article continues below chart.)

Estate, Gift, and GST Tax Schedule

Year Estate tax exclusion Top marginal estate & gift tax rates Gift tax exclusion GST tax exemption Basis
2004 $1.5 million 48% $1 million $1.5 million Step-up
2005 47%
2006 $2 million 46% $2 million
2007 45%
2008
2009 $3.5 million $3.5 million
2010 N/A 0% estate tax
35% gift tax
N/A Carry-over + $1.3 million
2011+ $1 million 55% $1.4 million (est.) Step-up

Blank cell = no change from previous year
GST = Generation-skipping tax

The bad news is that exclusions for estate and gift taxes, as well as the top marginal tax rates, are going to change often over the next seven years, making estate planning a bit more complicated than it already was. To make matters even more complex, the step-up in basis that your heirs get on appreciated assets will disappear in 2010 and then return in 2011.

Of course, Congress can pass another tax act and change everything again. So estate planning is much like shooting at a moving target.

Nevertheless, you must continue to plan your estate using traditional methods: wills, trusts, powers of attorney, life insurance, gifts, and charitable donations. To help you keep your eye on the target, here´s a summary of how the various estate-related exclusions and rates will change over the next seven years (see chart, above).

Estate Tax

The highest marginal estate-tax rate is now 45 percent. The estate tax will disappear in 2010. Then, unless Congress renews the Tax Relief Act, the rate will spring back to 55 percent in 2011.

The estate tax exclusion (also known as “credit equivalent”) is now $2 million and will increase to $3.5 million by 2009 (double that for married couples). It will become irrelevant in 2010 when the estate tax disappears, then revert back to $1 million in 2011. The exclusion is the amount that you can pass along to your heirs free of estate taxes; everything above that level is subject to the tax.

Gift Tax

The top marginal gift-tax rates will change along with the estate tax rates, step-by-step, except for the year 2010. While the estate tax disappears in 2010, the top marginal gift tax rate will be 35 percent. The gift tax exclusion, currently $1 million, will remain at that level.

GST Tax

For inheritances or gifts that go directly to your grandchildren, the IRS taxes you twice. First your estate must pay the usual estate tax, and then a generation-skipping transfer (GST) tax. Regardless of the value of the assets that you transfer to your grandchildren, the GST tax rate is always the same as the highest marginal estate-tax rate, which in 2008 is 45 percent.

Each individual is entitled to a lifetime GST exemption for transfers made directly to grandchildren. That is exemption is currently $2 million. After 2005, it continues to match the estate tax exemption.

Step-up in Basis

Under current law, when you pass stock and other assets that have appreciated in value to your heirs, they get a step-up in basis to market value at the time of your death.

Under the Tax Relief Act, this step-up in basis changes in 2010: Along with your appreciated assets, your heirs will inherit your original (carryover) basis, increased by a maximum of $1.3 million. That could result in higher capital gains taxes when they sell the assets. But then in 2011 the full step-up in basis returns.

Action Plan

What action you should take in response to these changes depends mainly on the value of your estate. If you have an estate with assets worth less than $2 million (or less than the revised exclusion amount in any future year), you´ll probably need no further action with respect to estate taxes.

If your assets are worth more than $2 million, a good strategy may be to plan for a current-year exclusion scenario: i.e., the exclusion is $2 million and the top marginal tax is 45 percent. For example, if you have assets greater than $2 million, then plan to keep your estate at a valuation just less than the exclusion as it gradually increases to $3.5 million by 2009. But do so only with advice from your lawyer, because all of your decisions depend on a projected valuation of your estate and your health.

Gifting Strategy

For people with modest estates, gifting strategies, which take advantage of the $12,000 annual gift tax exclusion ($24,000 for married couples), are less imperative now that the estate tax exclusion is increasing. But for those with large estates, gifting is just as important as before. If the estate tax is abolished after 2010, and your gifting was unnecessary after all, then nothing is lost. But if the tax gets resurrected in 2011 as planned, gifting may save you millions of dollars.

If you plan to pass assets to your heirs that will appreciate significantly in value by 2010, you might want to purchase a life insurance policy with a 10-year term. Such a policy will help your heirs pay the capital gains taxes they´ll incur if they inherit the assets with the carryover basis.

If you´re not sure what to do about the changes in the tax law, meet with your lawyer and financial adviser to evaluate your current estate plan in light of the new law. And keep in mind it will probably change again before 2010.

About the Author

Alan G. Orlowsky, President of Orlowsky & Wilson, Ltd. in Lincolnshire, Illinois, has been counseling people on estate planning for 28 years. He previously worked for the IRS in its Estate and Gift Tax Division. He also worked for the Deloitte & Touche accounting firm, and he has taught taxation and accounting at Loyola University of Chicago, School of Business.

Al is a contributing author of the book 21st Century Wealth (Esperti Peterson Institute, Denver, 2000), and has written numerous articles on the subject of estate planning. Contact Alan Orlowsky by email or call 847-325-5559.

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