With the prospects for estate tax repeal looking grim as Congress undergoes a political power shift, it's time to start thinking again about how to deal with the estate tax. With the possibility of estates as low as $1 million being subject to tax in 2011 and later, the estate tax is something that many prudent retirement investors need to consider. Even ordinary people can accumulate extraordinary amounts of wealth, simply by choosing investments with good long-term returns. Subscribers to the Motley Fool Stock Advisor newsletter, for example, have already found stocks like bebestores (NASDAQ:BEBE) that have helped Tom and David Gardner's portfolio more than double the return of the S&P 500. Many successful long-term investors might be surprised to discover that the government considers them rich enough for the IRS to take a bite of their investment apple after they die.
If you're on the road to extraordinary wealth, you don't want Uncle Sam to take half of your money from you and your family. However, that's exactly what the estate tax can do to wealthy people. If you're interested in preserving your estate for future generations, you need to consider the actions you can take now to reduce any future estate-tax liability.
Give it away now
Your first thought about how to reduce your estate before your death might be pretty simple: Just wait until right before you die, then give everything to your family members. That way, you would die penniless, and there wouldn't be anything left for the government to tax. Unfortunately, however, Congress and the IRS figured out that trick a long time ago. While estate tax only applies to transfers of wealth at death, a gift tax may apply if you give assets away during your lifetime. The estate tax and the gift tax work hand in hand to make sure that the wealthy can't find easy ways to work around transfer taxes.
However, there are a number of ways that you can make gifts without having to pay the gift tax. First, the so-called gift tax annual exclusion allows you to give up to $12,000 each year to any individual you choose, without any gift tax impact. If you're married, you and your spouse can double that amount to each gift recipient. For instance, if you're married and have four children, you and your spouse could give $24,000 each year to all four children, for total gifts of $96,000. In light of the 55% estate tax rate that could potentially apply in 2011 and later, that gift could save you more than $50,000 in estate tax. The $12,000 amount is indexed for inflation; it started at the $10,000 level, and it's likely to continue to rise over time.
In addition to these annual exclusion gifts, you are allowed to give an unlimited amount of money to cover medical or educational costs. For example, if you have a child in college with tuition of $40,000 a year, you can pay the entire $40,000 on your child's behalf without worrying about the $12,000 annual exclusion limit. In paying for these expenses, however, it's crucial that your money go directly from your bank account to your child's educational institution or health-care provider. If you instead write a check to your child, then let your child pay tuition or medical costs from the child's account, you won't get the benefit of the unlimited exclusion. Instead, you'd need to file a gift tax return.
Furthermore, just as the estate tax doesn't apply to estates less than a certain amount, the law allows you to make additional gifts up to a lifetime limit of $1 million without having to pay any gift tax. That's in addition to any gifts covered by annual exclusions or the unlimited exclusion for medical and educational costs. If you make such gifts, you have to file a gift tax return, even if you don't owe any tax; this assists the IRS in keeping records of your lifetime gifts. More importantly, any amount of this $1 million you use during your lifetime reduces the amount of money you can transfer at your death without paying estate tax. For instance, in 2007, estates of less than $2 million are generally not subject to estate tax. However, if you make gifts now that use your entire $1 million gift tax exclusion, then die in 2007, you could only transfer $1 million through your estate without having to pay estate tax. In essence, the $1 million gift tax exclusion you used would be added back into your estate for purposes of calculating estate-tax liability.
Finally, gifts to charity aren't subject to gift or estate tax. Of course, money that you give to charity won't go to your heirs. However, given the choice between giving a dollar to charity or paying $0.55 in estate tax and leaving $0.45 to heirs, many people choose the charitable option.
Find a balance
Using these methods to make gifts that will reduce your taxable estate can be a prudent move. However, you need to give an amount that meets all of your needs. While you want to take advantage of reducing estate tax, you also need to hold onto enough of your assets to meet your own financial needs during your lifetime. Striking a balance between these competing factors is challenging, but with planning and effort, you can come up with a strategy with which you're comfortable.
The estate tax doesn't affect many people, but if you're wealthy or have aspirations of becoming so, it may well affect you. Taking steps now to minimize its impact on your family's financial situation will leave you in the best position to deal with whatever new estate-tax twists Congress devises.
Further fiduciary Foolishness:
You can find helpful information about the estate tax and other types of taxes that affect investors in The Motley Fool's Tax Center.
For more solid advice to help you plan for your financial future, try a free 30-day subscription to Motley Fool Rule Your Retirement.
Fool contributor Dan Caplinger's annual gifts usually consisted of a crisp new $10 bill from his grandmother, but he wasn't jealous of the rich kids. He doesn't own shares of bebe stores. The Fool's disclosure policy keeps on giving.
