1/05/2000

Avoiding Estate Taxes

There are five major taxes that cover every aspect of our lives:

1. when you spend - sales tax
2. when you sell - capital gain tax
3. for owning items - property tax
4. when you earn money - income tax
5. and when you are done with your assets - estate taxes.

In this article I will explain to couples the powerful use of the by-pass or credit shelter trust. This trust arrangement enables a couple to utilize each of their estate tax credits, which could dramatically reduce their estate tax liability.

What Are Estate Taxes?

The United States actually has a unified tax system -- which means that there is one tax structure that taxes cumulative transfers made during your life and upon your death. It is called the Unified Estate and Gift Tax System. The estate tax component of this unified system is a tax on the fair market value of all assets owned or controlled by you at your death. Estates that exceed the unified credit amount start paying taxes at the rate of about 22%.

What is the Estate Tax Credit?

The good news is that Uncle Sam does not intend to tax all of your estate. To this end, the federal government has given each of us a credit in order to reduce our estate and gift tax burden. In the year 2000, the credit is $220,550 which will enable an individual to pass a total estate valued at $675,000 tax fee. The estate tax credit will increase every year till 2006 at which time one will be able to avoid estate taxes on an estate of $1 million with a credit equal to $345,800.

For many people it is not difficult to have an estate valued at $1 million or more. Once real estate values, life insurance proceeds, investment assets and retirement plans are added up, it is easy to exceed the $1 million mark.

Utilizing Your Estate Tax Credits

Many couple leave their heirs with unnecessary estate tax bills because they fail to use both estate tax credits -- one for each person. The common error happens like this: all assets at the death of the first spouse are left to the surviving spouse. No problem so far because one can leave an unlimited amount of assets to a spouse without incurring any estate taxes. This is because assets transferring to a spouse pass under the rule of Unlimited Marital Deduction. However, with all the assets in one person's name (the surviving spouse) and only one estate tax credit to use, it can easily result in an estate over the credit limit. If so, estate taxes will be due. For example:

Example 1: John & Mary Sample. John has $400,000 of assets in his name. Mary has $200,000 of assets in her name. Jointly held assets total $350,000. There is also a life insurance policy on John valued at 250,000. Upon his death all assets are left to Mary. She now has an estate valued at $1,200,000. If she passes away in the year 2000, she will have an estate tax bill of $427,800 less her credit of $220,550 = $207,250 in taxes. However, the Sample family did not have to pay $200,000 in estate taxes if they had done some simple estate planning.

How to Avoid Estate Taxes

One of the best ways to reduce estate taxes for married couples is to ensure that both estate tax credits are utilized. After all, the government has given each of us this credit, so why not take advantage of it and stop giving money to Uncle Sam. If John and Mary Sample had established a by-pass or credit shelter trust they could have utilized both estate tax credits and saved $207,000. Here is how:

Example 2: John & Mary Sample. As in the previous example, John has $400,000 of assets; Mary $200,000; jointly held assets total $350,000; and the $250,000 of life insurance on John. Upon his death, the $650,000 of assets in John’s name are passed to a family trust. There is no estate tax because the use of this trust enables him to use his estate tax credit -- thus allowing the transfer of $675,000 free of tax in 2000. The remainder - $550,000 - goes to a marital trust also free of estate tax because of the unlimited marital deduction. Upon Mary’s death, the family trust will pass to its beneficiaries (often the children) without estate taxes no matter how much the trust is worth at that time. The assets in the marital trust will pass to its beneficiaries but Mary's estate tax credit will shelter all or part from estate taxes. If the value of the remaining assets are still at $550,000 (or any amount below $675,000 in the year 2000), all of this will pass without estate tax.

Thus, John and Mary have both used their estate tax credits and saved their heirs over $200,000 in estate taxes.

How does this trust arrangement affect Mary and her need to use these assets for the remainder of her life, particularly if she lived well beyond 2000? Relatively little actually. In most cases the trusts will be drafted to allow Mary full access to the income and principle of the marital trust, and full access to the income of the family trust. While she may still have access to the principal in the family trust for specific reasons, the access cannot be unrestricted or the trust will be included in her estate.

Using this by-pass will enable couples to shelter an estate of $2 million in the year 2006!

Are there Alternatives?

Sure there are many ways to reduce one's estate tax liability. Their suitability depend on your goals, the size of your estate and more. For a list of alternatives, please read my earlier article on Estate Planning - A Sample of Concepts to Consider. However, having established by-pass trusts, you will be at least certain to use both estate tax credits.

What if Our Estate Exceeds Our Tax Credits?

If your estate will surpass the $2 million in joint credits in 2006, then you will indeed be subject to estate taxes on the excess. If this a realistic possibility then you need to incorporate alternatives into your estate plan to further reduce estate tax liability. There are also creative ways to pay unavoidable estate taxes.

The important point is not the method, but that you do some intentional estate planning. In doing so, you could save your heirs a large tax bill.

Please send questions or comments to dcoffin46333@wradvisors.com.