Understanding the Federal Estate Tax

One of your estate planning goals may be to ensure your family's financial security by providing a generous legacy. But estate, gift, and generation-skipping transfer (GST) taxes can significantly reduce the value of an estate. Without careful planning, these taxes could claim a large portion of the assets you intended to leave to your loved ones.

Although current law repeals the federal estate tax and the GST tax in 2010, the law’s sunset provision will end the repeal in 2011. Unless new legislation is enacted, the law will then revert to the rules that applied prior to passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The uncertainty of what lies ahead makes estate planning as important today as it has been in the past.

The purpose of this overview is to give you a better understanding of federal transfer taxes and their potential impact on your estate. Knowing when and how these taxes come into play is the first step in designing and implementing an effective planning strategy.

Your Gross Estate

Basically, your gross estate is the value of all the property in which you hold an interest at your death. The value of certain assets may be included in your estate even though someone else holds legal title to the property. Here’s a partial list of property that would be included as part of your gross estate.

Your personal possessions
Amounts you have on deposit in checking and savings accounts
Stocks, bonds, and other securities you own
Real estate you own
Your partnership and business interests
The proceeds of insurance policies on your life if you possess any “incidents of ownership” in them at your death
The value of insurance policies you own on the life of someone else
Debts owed to you
Your interest in retirement plans and individual retirement accounts
The value of any annuity you own that will continue to be paid to another beneficiary after your death
The value of jointly held property, except for any part contributed by the survivor (An exception: One half the value of property owned by you and your spouse is includable in your estate, regardless of who provided the consideration for the property.)
The value of property over which you possess a “general power of appointment” (usually in conjunction with a trust)

Valuing Your Gross Estate

The value of property for estate-tax purposes is its fair market value at the time of your death (or at the “alternate valuation date,” generally six months later). Fair market value is the price at which property would exchange hands between a willing buyer and a willing seller, both with reasonable knowledge of relevant facts. The tax law contains “special” valuation provisions for certain types of property, such as farm property and real estate used in closely held businesses.

Your Taxable Estate

Once the value of your gross estate has been determined, certain items are subtracted from the total to arrive at your taxable estate. Deductible items include:

Administration and funeral expenses
Claims against your estate, such as your mortgage, valid debts you owe, and unpaid property or income taxes
Any loss resulting from a fire or other casualty that occurs during the estate administration period if the loss isn’t reimbursed (for example, by insurance)

Your estate may be entitled to other important deductions as well.

The Unlimited Marital Deduction

Generally, your estate may deduct the value of all property passing from you to your surviving spouse in a qualified manner. The practical effect of the marital deduction is that you’re generally allowed to pass an unlimited amount of assets to your surviving spouse free of estate tax. However, leaving all property outright to your spouse may not be the best estate planning approach, especially if the value of your combined estates is greater than the estate-tax credit exclusion amount (discussed later). Although your assets will pass tax free to your surviving spouse, when your spouse dies, the assets that remain will be included in his or her estate for tax purposes, potentially reducing the amount your children or other heirs eventually inherit.

The Charitable Deduction

Your estate may be entitled to a charitable deduction for the value of any property you give to a qualified charitable organization. The estate-tax charitable deduction isn’t subject to percentage limitations, so your executor or personal representative may claim a charitable deduction for the full value of the gift.

Computing the Federal Estate Tax

The accompanying table summarizes the federal estate-tax computation. As you can see, the value of any lifetime gifts you made that gave rise to a gift tax must be added to your taxable estate. The estate-tax rate is applied against this total. Once this tentative tax is determined, any gift taxes you paid are subtracted.

Every estate is allowed a credit that permits a certain amount of assets to pass to beneficiaries free of estate and gift tax. Generally, no estate tax will be due if your total taxable estate and taxable lifetime gifts are less than or equal to the applicable credit exclusion amount — $3.5 million in 2009. In 2011 the exclusion amount reverts to $1 million and the top estate-tax rate jumps from 45% to 55%.

Gross Estate

– Allowable Deductions

= Taxable Estate

+ Taxable Lifetime Gifts

= Total

Tentative Tax from Estate-tax Table

– Gift Tax Paid on Lifetime Gifts

= Estate Tax Before Credits

– Estate-tax Credit

= Estate Tax Owed

The Generation-skipping Transfer Tax

You may want to arrange for some of your assets to benefit a grandchild or someone else much younger than you are. But be aware that the tax law limits the value of the assets you can pass tax free to individuals who are more than one generation below yours. The generation-skipping transfer tax is designed to prevent families from avoiding a generation’s worth of estate taxes by transferring assets to grandchildren rather than to children. The GST tax rate is equal to the highest federal estate-tax rate and must be paid in addition to estate and gift taxes.

But there is some good news. A cumulative GST tax exemption allows you to transfer up to $3.5 million (in 2009) to grandchildren and others free of the GST tax ($7 million if you and your spouse agree to split the gift). Also, the GST tax generally won’t apply to transfers made to a grandchild whose parent is deceased. As with the estate tax, the GST tax is repealed in 2010 and returns in 2011.

Although minimizing taxes is a worthy objective, preparing for your loved ones’ financial security is an equally important goal of estate planning. Strategies are available to help you both reduce your tax liability and preserve more of your assets for the benefit of those you love and the charitable causes you support.

This publication is an advertisement prepared by NPI for the use of the sender. It is not to be considered legal, accounting, tax, or investment advice. The information is general in nature and may or may not be appropriate to you. Before applying anything you read to your personal or business situation, you should seek professional advice.