Avoid This Million-Dollar Mistake

Years ago, the government set in motion a strategy that was designed to eliminate one of the biggest bills you may ever have to pay. But, like a movie villain who uses a 24-hour countdown when five minutes would do the job just as well, the timeline for that strategy extended just long enough that it may now get reversed.

Eight years ago, the estate tax affected anyone with a net worth of $675,000 or more. Under a tax cut passed in 2001, though, that figure rose gradually to $3.5 million this year. Moreover, in 2010, it's slated to go away entirely. But because the 2001 law included a so-called sunset provision, the elimination of estate tax would last only one year -- unless a new law extended its repeal.

Now, with high budget deficits and an ambitious spending program, the current administration has proposed keeping the estate tax at its current level. And although a permanent $3.5 million limit would keep the vast majority of people from dealing with the estate tax for now, it's still something you'll need to keep in mind in order to avoid the prospect of a huge tax bill.

Who pays the most
Of course, the estate tax has the greatest potential impact on the extremely wealthy. Because the estate tax rate is currently 45%, and may sit at that level beyond 2010, the tax is no laughing matter for those with assets above the exemption limit. Consider, for instance, the potential impact on these well-known business entrepreneurs.

Source: Yahoo! Finance.

These high rates are likely at least one of the considerations that motivate some of the world's biggest philanthropists. Microsoft's (NASDAQ:MSFT) Bill Gates, for instance, has given billions to his Gates Foundation, as has Berkshire Hathaway (NYSE:BRK-B) chairman Warren Buffett. Because charitable gifts qualify as deductions against the estate tax, each dollar they give essentially saves them $0.45 in tax.

Why it matters to you
Sure, it's hard to feel bad about billionaires having to pay taxes. But a Capgemini study from 2008 counted at least 3 million millionaires in the U.S. -- many of whom might face potential tax liability if the estate tax doesn't get repealed permanently.

In addition, even if you don't have that much money now, you may have a lot more later in life. And if the $3.5 million exemption is not indexed for inflation, then your net worth could easily catch up with the tax over time.

What to do
To avoid paying tax unnecessarily, you have to plan. Although the actual strategies can get complicated, they essentially boil down to making gifts of assets on an ongoing basis during your lifetime in a manner that lets you reduce your taxable estate while preserving your family's overall wealth.

Specifically, some strategies include:

• Creating trusts to take maximum advantage of estate tax exemptions.
• Holding life insurance in a way that bypasses taxation.
• Making gifts to charity that can also benefit your family.

A good estate planning attorney can help you figure out the best strategy.

Although this sounds like bad news for those who had hoped that the estate tax repeal would be made permanent, the proposal still has to get through Congress. There's still a chance that you won't have to worry about this potential tax trap. But in the meantime, it's smart to be prepared for whatever happens.

For more on preserving your wealth, read about:

• How you can be rich in just three years.
• The biggest bubble the world has ever seen.
• What stocks will you regret not buying?