How Does The Estate Tax Work?
After your death, if your estate if worth $2 million or more (this limit is scheduled to go up to $3.5 million in 2009) then the executor of your estate must file an estate tax return. The estate tax return will list the value of all your assets such as real estate, investments, retirement accounts and personal property.
If all $2 million of assets pass to your spouse, although an estate tax return still must be filed, no estate tax is due at that time, no matter how large the size of your estate. This is called the spousal exemption. This exemption only applies if your spouse is a U.S. citizen.
Upon the death of the surviving spouse, estate taxes will be calculated and due when the estate tax return is filed.
When determining if your estate owes taxes, first a calculation is done which assumes your entire estate is subject to tax.
Next, a credit, called the unified credit, is applied. Each person has a unified credit of $780,000 (scheduled to go up to $1,455,800 in 2009). This means your estate does not have to pay the first $780,000 of estate taxes. The unified credit allows you to pass along approximately $2 million of assets, estate tax free.
Think your estate is well under that $2 million limit? If you own life insurance, think again.
Depending upon how your life insurance policy is structured, the proceeds may be includable in your taxable estate.
For example, let’s look at a married couple with a home valued at $1 million, and investments and personal property valued at $500k. They think they have a $1.5 million estate, and they have given no thought to estate planning. They have forgotten that his company provides $1 million of life insurance.
Upon his death, the life insurance proceeds, if paid to the spouse, become a part of the taxable estate. Now she has an estate of $2.5 million. Due to the spousal exemption, she will not owe any estate tax at the time of his death. She thinks all is well.
However, because they did not plan prior to his death, upon her death, their estate has forever lost the ability to avoid paying estate tax on the portion of the estate that is in excess of $2 million. In this case, the $500,000 of the estate subject to estate taxes would result in estate taxes of $225,000. The estate could have paid nothing.
Estate Taxes For Married Couples
You would think, if you can pass along $2 million, per person, without estate taxes, than as a married couple, you should be able to pass along $4 million without being subject to estate taxes. Unfortunately, it doesn’t work that way today; although it may get that easy in the future, as both 2008 presidential candidates are proposing positive changes.
But right now, it’s rather complex. Let’s look at another example:
Bob and Sue have assets of exactly $4 million. Bob passes away, and all assets pass along to Sue. Because of the spousal exemption, no estate taxes are owed at this time.
Several years later, Sue passes away. The unified credit is used, and so $2 million passes along to the children, estate tax free. Estate tax is owed on the next $2 million, resulting in a $900,000 estate tax bill. This estate also could have paid nothing.
Planning Right Can Save $900,000 in Estate Tax Per Married Couple
In both examples, all estate taxes could easily have been avoided by setting up a Revocable Living Trust that had a Marital and Family Trust provision, also known as an A/B trust.
I’ll explain the process:
- A revocable living trust is established. A revocable trust can be changed at any time and allows you and your spouse to manage your assets, without restriction, just as you always have.
- This revocable living trust contains language that explains what is to happen. It says that upon the death of either spouse, a portion of the estate is to be placed in a Family Trust, also known as a B Trust. The B Trust is for family members other than the spouse; usually the children. Not to be insensitive, but we’re all going to die someday, so to help remember which is which, remember that “B” holds the assets of the person “below ground”.
- The other portion of the estate is to be placed in a Marital Trust, or A Trust. The A Trust is for the surviving spouse. Think of “A” for the person “above ground.”
In the case of Bob and Sue, here’s how it would work:
Upon Bob’s death, half of the assets are placed in the Family Trust, or B Trust. Bob’s unified credit would be applied to these assets, and no estate tax would be due. Sue is allowed to draw income from assets in the B Trust, and allowed to access principal if necessary.
The other half of the assets are placed into the Marital Trust, or A Trust. Sue retains full control and unlimited access to assets in the A trust.
Upon Sue’s death, her unified credit is applied to the estate tax assessed upon her assets in the A Trust, and her $2 million passes along, estate tax free.
Using this type of estate planning, Bob and Sue were able to put $900k of additional dollars into their children’s pockets, rather than into Uncle Sam’s.
