Estate Planning
START GIVING IT AWAY EARLY
By SmartMoney.com Staff
Updated on January 9, 2007.
THERE ARE THREE basic things to remember when getting started with estate planning:
The Estate-Tax Exemption
For 2006-2008 you can leave bequests (gifts to other individuals upon
your death) worth up to $2 million free of any federal estate tax. This
is the so-called estate-tax exemption. If you're married, both you and
your spouse are entitled to separate $2 million exemptions. Better yet,
the current $2 million figure is scheduled to increase to $3.5 million
in 2009. In 2010, the federal estate tax will supposedly be repealed
altogether.
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Until that day comes, a married couple with kids and a
substantial net worth can optimize the estate-tax exemption with a
bypass trust arrangement. When the first spouse dies, $2 million of
estate-tax-free money goes into the bypass trust, which is set up for
the benefit of the kids. The surviving spouse typically gets any
remaining assets owned by the deceased spouse. This drill ensures that
both spouses take full advantage of their respective $2 million estate
tax exemptions, meaning a total of up to $4 million can be left to the
couple's heirs without Uncle Sam taking a bite (thus "bypassing" the
IRS). See "You've Got to Start Somewhere" for the story on bypass
trusts.
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The Gift-Tax Exemption
You can also give away a cumulative total of up to $1 million to
relatives, friends, whomever during your life without owing any federal
gift tax. This is the so-called gift-tax exemption. If you're married,
both you and your spouse are entitled to separate $1 million gift-tax
exemptions. Unlike the estate-tax exemption, however, the gift-tax
exemption won't increase. Instead, it will remain fixed at the current
$1 million level.
Gifts made under the so-called $12,000 tax-free-gift rule
(more on that below) will not trigger any federal gift taxes, nor will
they reduce your federal gift- or estate-tax exemptions. However, gifts
in excess of the $12,000 "freebie" will reduce both exemptions dollar
for dollar. Only if you're so generous during your lifetime that you
completely burn through your $1 million gift-tax exemption will you
have to start paying federal gift tax. Even then, the tax only hits
gifts in excess of the $12,000 figure.
Bottom line: Relatively few people will ever reach the point of actually owing any federal gift tax.
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The $12,000 Annual Gift Tax Exclusion
For those with really large estates, the $2 million estate-tax
exemption isn't enough. That's where the $12,000 tax-free gift rule
comes in.
The benefit of making tax-free gifts is twofold: It
reduces your taxable estate, and it shifts the taxable income from the
gifted money to your kids, who may be taxed at a lower rate than you.
This $12,000-a-year strategy works particularly well for those who wait
until late in life to start serious estate planning.
Let's say, for instance, you and your spouse have an
estate worth about $5 million and you've built in almost no protection
against the IRS. If you both die tomorrow, the federal estate tax could
be as much as $1.35 million. Now, here's how a little financial
maneuvering can pay off big. First, you have a lawyer outfit each of
your wills with bypass-trust language. The bypass-trust arrangement
shelters $4 million from federal estate taxes. Then, assuming you have
two children (both married) and four grandchildren, and assuming you're
able to give away $192,000 a year ($12,000 from each of you to both
children, their spouses and four grandkids), you can cut that tax bill
to almost zero in just a few years. (Gifts under the $12,000 rule don't
cut into your gift- or estate-tax exemptions.)
