The estate tax is a double-edged sword. On one hand, since you don't have to worry about paying any estate tax unless your estate exceeds a relatively high amount -- $2 million in 2006 -- having to actually pay it means you've been pretty successful in accumulating wealth. On the other hand, at rates of up to 46%, the estate tax imposes some of the highest taxes on the books in the Internal Revenue Code.
In addition to the $2 million exemption, there are a number of other ways to reduce or eliminate your estate tax liability -- one of the most useful being the bypass trust, which we'll discuss more in a moment. For now, let's consider a few other options. First, keep in mind that anything in your estate that you leave to charity is eligible for a deduction. In addition, with some minor exceptions for non-citizens, Congress allows married couples to bequeath an unlimited amount of money to each other free of estate tax, thereby granting a so-called marital deduction from the estate tax for gifts made to spouses.
The marital deduction, however, can mislead married couples into thinking that all they have to do is leave everything to each other at death. Because they have an unlimited deduction, they reason, they will owe no tax. But even though they are correct that they would owe no estate tax if one of them dies, they may unwittingly create a big estate tax problem down the road.
The typical scenario
Consider two spouses, each of whom owns $1.5 million in assets. They have a very simple estate plan: When one spouse dies, the surviving spouse receives all the assets; and after the other spouse dies, all of the assets go to their children.
When the first spouse dies, no estate tax is due, for two reasons. First, the estate of $1.5 million is below the $2 million exemption amount; and second, the estate is entitled to a full marital deduction because the entire $1.5 million in the estate is going to the surviving spouse. But as a result, after the estate is settled, the surviving spouse will have a total of $3 million in assets: the $1.5 million received from the estate plus the $1.5 million the surviving spouse already owned.
The problem arises when the surviving spouse dies. Because the total estate is worth $3 million, the estate will be subject to tax on the amount in excess of the exemption -- in this case, $1 million. Not considering other deductions, the estate may owe as much as $460,000 in estate tax as a result.
Isn't that unfair?
At first glance, it seems so. If each spouse had a $2 million exemption, then together, they should have been able to combine their exemptions and shelter a total of $4 million from the estate tax. Since they owned a total of only $3 million in assets, they shouldn't have had to pay any tax at all. Yet this unfair result came about because of a mistake this couple made: By leaving everything to each other outright, they essentially wasted one of their $2 million exemptions.
One way to avoid this unfortunate result is for the spouses to change their wills to leave everything to their children rather than to the surviving spouse. The first spouse's estate is small enough to avoid tax, and since the surviving spouse does not receive anything from the estate, the surviving spouse's own assets will remain comfortably below the threshold for estate tax. However, this means that the surviving spouse will have less money for expenses and may face the prospect of asking the children for assistance if the surviving spouse's own assets run out. Most couples are extremely uncomfortable with this possibility.
How can you solve the problem?
By using a relatively simple estate-planning technique involving trusts, you can take advantage of both of your exemptions while making sure that you provide for your spouse after your death. The type of trust involved is called a bypass trust because it is drafted in a manner ensuring that its assets will be excluded from the surviving spouse's estate, bypassing taxation when the surviving spouse dies.
The bypass trust often names the surviving spouse as the primary beneficiary, allowing distributions to be made for expenses related to the surviving spouse's health, education, or support. Although this "ascertainable standard" technically restricts the manner in which the surviving spouse can spend trust assets, it fulfills the purpose of forcing the IRS to exclude the trust's assets from the surviving spouse's other assets in making its estate tax computation when the surviving spouse dies. This exclusion can save hundreds of thousands of dollars in estate tax.
Nevertheless, some couples are uncomfortable with the idea of putting assets into a trust. They see it as locking up their money and losing control of how they can spend it. In considering a bypass trust, you should keep a few things in mind. First, the ascertainable standard contains considerable flexibility to allow for a wide variety of needs that may arise. Second, the surviving spouse can retain a substantial amount of assets outside the bypass trust, and the surviving spouse can use these outside assets for any purpose. Perhaps most importantly, the surviving spouse can act as the trustee of the bypass trust, as long as the surviving spouse respects the formalities of the trust and acts in accordance with its provisions.
Keeping your estate planning simple is a reasonable goal. But when too much simplicity ends up costing you a large amount of money, you should do what it takes to protect yourself. Using a bypass trust adds only a small amount of complexity, yet it protects your family from unnecessary estate taxes.
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Fool contributorDan Caplingerwelcomes your feedback.