What is the Estate Tax?

The estate tax is a tax on accumulated wealth. So if you die and you are considered wealthy (by the estate tax rules then in effect), your estate is subject to tax. It’s the government’s way of making sure no family gets “too rich” by passing wealth from generation to generation.

Your gross estate includes the value of all property in which you had an interest at the time of your death, including all retirement accounts. Your gross estate also will include the following:

• Life insurance proceeds payable to your estate or, if you owned the policy, to your heirs.
• The value of certain annuities payable to your estate or to your heirs.
• The value of certain property you transferred within three years before your death.
• Trusts or other interests established by you or others in which you have certain powers.

Your taxable estate is your gross estate less the allowable deductions:

• Funeral expenses paid out of your estate,
• Debts you owed at the time of death, and
• The marital deduction (generally, the value of the property that passes from your estate to your surviving spouse).

You see that one of the allowable deductions from your estate is property that you leave to a spouse. But this is no gift from the IRS. Assets you leave to a spouse become part of the surviving spouse’s estate and will be taxed when the surviving spouse dies.

Take a look at Figure 1. Here we have a hypothetical example of a couple with $3 million of assets. For 2006, each person can pass $2 million estate tax free. Additionally, you can pass unlimited amounts to your spouse estate tax free. But you don’t want to pass your entire estate to your spouse, as that can conceivable make your surviving spouse’s estate too large and cause him or her to pay estate taxes unnecessarily as you see in Figure 2. In other words, the rule with estates is this: you can leave your estate to your spouse OR you can get an exemption from the IRS.

Therefore, the goal is to leave your exempt amount to someone other than your spouse (e.g. children) or you lose it. Because smart attorneys long ago realized that surviving spouses wanted to have this money yet also did not want to create a situation where estate taxes would be due, they invented the bypass trust, Figure 3.

Your exempt amount goes to this trust and your surviving spouse may use it for “health maintenance and welfare.” In other words, your spouse can use these funds left in the bypass trusts to maintain his or her standard of living. Once your surviving spouse dies, the funds pass to your heirs (e.g. children). The good news is that at your death, you leave the exempt amount to the bypass trust and these funds are now out of your estate and your spouse’s estate. They can grow infinitely and will never be subject to estate tax when they pass to the trust beneficiaries. Voilà—the attorneys have created the cake that you can have and eat. Your spouse can access the funds if needed, the funds are not counted in the spouse’s estate, and you use the exemption that IRA gives to every individual.

So what does this have to do with your IRA?

You may be one of the fortunate few who have the following problem: Your retirement funds are such a large part of your estate that in order to pay estate taxes, part of your retirement funds need to be liquidated. For example, you are a married individual with a $4 million estate and $2.5 million of that is an IRA.

First, some good news. You can use your IRA toward your estate exemption. Your beneficiary can be the above mentioned bypass trust. Because it is constructed as a conduit trust for the ultimate beneficiaries who are people (some children are people), those beneficiaries get the benefit of the lifetime stretch.

The bypass trust simply takes the annual required minimum distribution from the IRA and distributes it to the beneficiaries. Because the trust distributes all of its income, it pays no tax. So your situation is now the following (using 2006 figures):

• $2 million of IRA left to bypass trust and exempt from estate tax.
• $2 million other assets owned by surviving spouse.

When the surviving spouse dies, assuming the estate does not grow, all of the assets will be exempt and this family will have no estate taxes due.

Figure 1: Bad Estate Division

Bad Estate Plan Example

Family Assets: $4 Million

Figure 2: Delay Problems to Wife’s Death

Figure 3: Proper Division Through Credit Shelter Trust

The basic idea is to make sure that each spouse fully uses his or her estate tax exemption (often called unified credit). These are the amounts per current law:

Table 4.1

In 2010, there will be no estate tax, and then it returns again in 2011 with a $1 million exclusion per person. Of course, this is all subject to change as Congress changes tax rates with some frequency.

Based on this fundamental understanding, you see why it may not be a good idea to die rich. If you have a large retirement plan, it could be subject to both income tax (up to 35% federal plus state income tax) and estate tax (up to 46%). But if you’ve stayed awake this far, the solution has occurred to you. Eureka! You’ll give away all of your money before you die!