Is The Death Tax Gone?

• The Death Tax Not Gone

• Death taxes still live

The death tax not gone

The "death tax" sounds abstract, but it matters. The federal estate tax hasn't disappeared—claims that it has are overstated. Many people wrongly believe it's been repealed.

The federal estate tax was reduced, not eliminated. Under the 2001 Tax Act, the top rate drops from 55% to 45%, and the exemption rises from $1 million to $3.5 million by 2009. In 2010 alone, there is no estate tax. But the law expires at the end of 2010, and unless Congress acts, the tax returns in 2011 at 55% with a $1 million exemption.

Death taxes still live

The 2001 Tax Act phases in changes through 2009. The top rate gradually falls from 55% to 45%, and the tax-free exemption climbs from $1 million to $3.5 million.

In 2010, there is no federal estate tax. But a sunset clause in the law means all these changes expire after 2010. Starting in 2011, the tax returns with a 55% top rate and a $1 million exemption—unless Congress extends the repeal.

Congress may extend the repeal beyond 2010, or opponents may overturn it before then.

Most people don't think about estate taxes until they have to. Elder law and estate attorneys handle these issues routinely. Everyone should have a will. Those with moderate to large estates benefit from working with an estate planning attorney who can review their finances and advise on how tax changes affect them.

Keeping wealth intact

With Congress debating the future of the estate tax, more people understand its impact. Trillions of dollars will pass between generations over the next few decades. Most want estate plans that protect assets and maximize what goes to heirs.

Federal and state estate taxes can significantly reduce what an estate passes down. One tool to cover these taxes is second-to-die life insurance, a policy designed specifically for this purpose.

A second-to-die life insurance policy pays its benefit only after both people have died. Because the payout is delayed, premiums are much lower than individual policies on each person, allowing for a larger benefit at the same cost.

Second-to-die insurance works well with the marital deduction, which lets a surviving spouse inherit any amount from their partner without federal estate tax.

You can reduce the first spouse's taxes to zero using the marital deduction. But unless both estates are small, that strategy often results in a much larger tax bill when the second spouse dies.

Second-to-die insurance is not right for everyone. Like all financial tools, it has trade-offs. Your estate planning attorney can recommend what works best for your situation.

Everyone wants to save on taxes, but not at any cost. A husband and wife might want to use the marital deduction fully at the first death. But they may not want to set up a trust to hold half their assets during the survivor's lifetime just to reduce taxes later.

The survivor would have limited control over those assets—perhaps a business or real estate they both valued.

Some couples prefer to leave everything to each other outright, even if that means higher estate taxes later.

They might still want a trust to manage assets after both are gone and children are young, but not to control assets between spouses.

Knowing this choice will increase overall estate taxes, they buy a second-to-die policy to provide the cash the estate will need.

A second-to-die policy doesn't eliminate estate taxes on its own, but it provides cash to pay them.

This way, parents can be confident that what they planned to leave their children and grandchildren will go to that purpose instead of to taxes.

Tax-sheltering the policy proceeds

Parents want the insurance proceeds free from tax in both estates. This takes more than just buying a policy.

A $1 million death benefit would be worth only $500,000 after taxes if the survivor's estate faces a 50% tax rate.

But if an irrevocable trust buys the policy, the death benefit avoids taxes in both estates.

One approach is to have the trust authorize—but not require—the trustee to buy assets from your or your spouse's estate using the death benefit, or to lend money to the estates. If cash is needed for taxes, the death benefit is available to the executors without being taxed.

A recent IRS private letter ruling suggests another method. The trust agreement said the trustee was not required to pay the last-to-die spouse's estate taxes or use the insurance to cover that spouse's debts or expenses.

The trustee had the discretion to pay estate taxes and other expenses for either spouse, but was not required to do so.

The IRS ruled that the insurance proceeds were not taxable because the estate's executor did not receive them and the trustee had no legal obligation to use them for the estate. (PLR 200147039).

A private letter ruling applies only to the person who requested it, but these rulings typically reflect the IRS's general position.

Setting up an irrevocable trust requires careful planning with your attorney. Once the agreement is signed, its terms cannot be changed.