Leave More for Your Family

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By Roy Lewis
July 6, 2001

One of the most discussed provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 has to do with estate and gift tax issues and the reduction of applicable taxes. As you know, if you pass away with substantial assets, you are required to turn over some of those assets (in the form of taxes) to Uncle Sammy. Additionally, if you made gifts over certain amounts, you are also required to pay taxes. This act has substantially reduced the amount that you are required to pay by increasing the amount of assets that you can pass through to your beneficiaries before the tax kicks in.

Let's look at an example. Say that your cousin Willy passes away in 2002 with net assets of $1 million (net assets being the fair market value of his assets less any liabilities against those assets, such as a mortgage, plus the values of any IRA/pension accounts, life insurance, and some other assets that Willy may own or have an interest in). Under the old rules, Willy was allowed an exemption of $700,000 -- the amount that could be given to beneficiaries without estate taxation. Since Willy's assets were in excess of $700,000, he (or, more properly, his executor) would be required to pay estate taxes on an "excess" amount of $300,000. And the estate tax on $300,000 wasn't inconsequential.

The new rates and exclusion amounts
But, under the new act, Willy wouldn't owe one dime in estate taxes in 2002 because the amount that can be left to his beneficiaries is increased to $1 million. Here's a table that will allow you to compare and contrast the old and new rules to help you see how and when the increases kick in:

       Old            New            New Highest
Exclusion Exclusion Estate Tax

Year Amount Amount Marginal Rate
2001 $675,000 2002 $700,000 $1 million 50% 2003 $700,000 $1 million 49% 2004 $850,000 $1.5 million 48% 2005 $950,000 $1.5 million 47% 2006 $1 million $2 million 46% 2007 $1 million $2 million 45% 2008 $1 million $2 million 45% 2009 $1 million $3.5 million 45% 2010 $1 million REPEALED REPEALED

Repealed?

That's right. In 2010 the estate tax will be repealed. But the estate tax will be replaced with a procedure by which assets of the decedent would have a "carryover" basis to the beneficiaries. What does that mean? Under the current laws, the beneficiary receiving an inheritance does so at a "step-up" in tax basis.

Using your cousin Willy as an example, let's say that his entire estate consisted of 1,000 shares of stock purchased in 1970 for $100,000 and now worth $1 million. If Willy dies in 2002, that stock will be passed through to you without any estate tax. And you will then receive the stock with a cost basis of $1 million, despite the fact that Willy only paid $100,000 for the stock initially. That's called a "step-up" in cost basis. It's easy to see why this step-up in basis is important: You can now sell the stock for $1 million and not have to report any gain for income tax purposes. You simply shove the money in your pocket and go along your merry, millionaire way. 

But under the new law, in 2010 when the estate tax is repealed, instead of a full step-up in basis of the decedent's assets, the beneficiaries will receive the decedent's assets with a carryover basis. In the example above, that would mean that you would be required to take Willy's stock at a cost basis of $100,000. If you then sold the shares for $1 million, you would have a $900,000 long-term capital gain to report on your income tax return.

But don't panic quite yet; this example is very oversimplified. In fact, there are very large amounts for which there are exceptions: $1.3 million for individuals and $3 million for spouses. And, heck, 2010 is so far away, it's not really necessary to get into the nuts and bolts of the carryover basis issues. Just know that they're out there. But do understand that the repeal of the estate tax along with the carryover basis issues turns estate tax problems into income tax problems.  

Gift tax repealed also?
Nope, that's not going to happen. And that's one of the biggest misconceptions in the new law. As the law currently exists, the estate and gift tax exemptions are "unified." That means the amount of the estate tax exemption and the gift tax exemption are the same. And that will remain the case until 2010. At that time, the estate tax will be repealed (again, replaced by the asset carryover gambit), but the gift tax rules will remain in place. We can only assume that the gift tax has been left in place in order to discourage taxpayers from making tax-free transfers to individuals in a lower tax bracket.

So in 2010, the estate and gift tax will no longer be "unified" since the estate tax will be repealed. Instead, in 2010 the top gift tax rate will be reduced to the top individual income tax rate of 35%. Huh? Well, since the date of the law change is so far into the future, it's really not important at this time to go through all of the details. Heck, the law may change once (or even many times) before we all see 2010. But just remember, if you're doing some long-term planning, that the gift tax will NOT be repealed along with the estate tax.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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