START GIVING IT AWAY EARLY

By SmartMoney.com Staff
Updated on February 3, 2010.

Estate Tax Uncertainty: Since 2001, the federal estate tax has been scheduled to die in 2010. However, the tax is scheduled to come roaring back with much sharper teeth in 2011. Nobody thought our beloved Congress would allow the estate tax to expire this year, but it happened. We expect the tax to be restored sometime in 2010, but the issue of the effective date is very uncertain. If Congress tries to bring the tax back with a retroactive effective date of Jan. 1, 2010, it might be unconstitutional. Meanwhile, the federal gift tax rules for 2010 are the same as they were in 2009. Those rules are explained in this article. Until the uncertainty regarding the estate tax is resolved by legislation, this article will continue to explain how the federal gift tax and estate tax rules fit together under the regime that applied in 2009. In the context of this article, the important thing to understand right now is that the 2010 gift tax rules are the same as in 2009, and the strategies that worked last year should work this year too. That said, don’t make significant gifts without consulting your estate planning adviser.

THERE ARE THREE basic things to remember when getting started with estate planning:

Rules of Giving · The Federal Estate Tax Exemption · The Federal Gift Tax Exemption · The $13,000 Tax-Free Gift Rule

The Estate-Tax Exemption
For 2009 you can leave bequests (gifts to other individuals upon your death) worth up to $3.5 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 $3.5 million exemptions.

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, $3.5 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 $3.5 million estate tax exemptions, meaning a total of up to $7 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.

Gifts made under the so-called $13,000 tax-free-gift rule (more on that below) will not trigger any federal gift taxes, nor will they reduce your federal gift-tax or estate-tax exemptions. However, gifts in excess of the $13,000 "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 $13,000 figure.

Bottom line: Relatively few people will ever reach the point of actually owing any federal gift tax.

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The $13,000 Annual Gift Tax Exclusion
For those with large estates, the $3.5 million estate-tax exemption isn't enough. That's where the $13,000 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 $13,000-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 $9 million and you've built in almost no protection against the IRS. If you both die tomorrow, the federal estate tax could be $900,000 or more. 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 $7 million from federal estate taxes. Then, assuming you have two children (both married) and four grandchildren, and assuming you're able to give away $208,000 a year ($13,000 from each of you to both children, their spouses and four grandkids), you can cut that tax bill significantly in just a few years. (Gifts under the $13,000 rule don't cut into your gift-tax or estate-tax exemptions.)