Why Your Estate Plan Needs Work 

If you have an existing estate plan, it may include a bypass trust arrangement. This arrangement ensures that you and your spouse take full advantage of your respective estate tax exemptions. Wills using bypass trusts usually state that the bypass trust is funded with assets equal to a certain value. The will names the ultimate beneficiaries of the trust, typically the children. The amount that goes into the bypass trust gets included in the decedents gross estate for estate tax purposes. The decedents estate tax exemption then fully shelters the trust fund from any federal estate tax. The surviving spouse dips into the trust as needed to meet reasonable expenses.

Heres the new rub. Most wills call for the bypass trust to be funded with an amount equal to the current federal estate tax exemption without naming a specific dollar amount. Effective next year, the estate tax exemption jumps from $675,000 to $1 million. So, you may have more money in trust than you intended. Meanwhile, your spouse has control of less money.

For instance, assume you have a $1.4 million estate. You probably intended that $700,000 would go into the bypass trust if you died next year ($700,000 was the old-law exemption for 2002). The rest, $700,000, would go directly to your spouse, or to another trust. But, if your will provides that the bypass trust must contain the full estate tax exemption amount; $1 million would go to the bypass trust. That leaves your spouse only $400,000. While your spouse can dip into the bypass trust if necessary, he or she may be reluctant to do so, figuring the money is really meant for the kids.

Heres a possible solution. Consider changing your will. A change in will language can change the amount placed in the bypass trust. That way your spouse is sure to have enough after youre gone.

You can also have the opposite problem, too little money going to the bypass trust. Say your current estate plan says that $700,000 of your $1.4 million estate goes to the bypass trust if you die next year. The bypass trust beneficiaries are your children. Your spouse then would get the remaining $700,000. But, your spouse may have a substantial estate and doesnt need or want the money. So consider changing your will to take full advantage of the increased exemption amount. That gets more to your kids and less to your spouse, which is consistent with your family circumstances. Also, unless you make this change, you gain no benefit from the increased exemption amount granted by the new law.

  Review Your Life Insurance Coverage 

You may be carrying life insurance solely to pay the federal estate tax bill that will come due when you pass on. You may not need as much coverage because the estate tax exemption may increase a lot in the future. Also, the maximum tax rate may drop. But, be careful here. There is no guarantee that these estate tax law changes will be permanent. And, you may not be able to get life insurance again. Never alter a life insurance program unless you study all the issues carefully.

  You May Need a New Scheme for Your Valuable Home 

Heres another instance where you may want to change your existing estate plan. Suppose you have valuable homes worth between $700,000 and $1 million. Your current estate plan probably leaves these homes to your spouse. Under old law, that was an easy way to avoid an immediate estate tax hit since the home is worth more than the old-law exemption amount. A side effect of this plan forces you to leave most of your liquid assets to your children if you leave them anything at all. The end result: your spouse ends up with one big illiquid asset (the house), while your children receive a bunch of liquid assets (investments, retirement accounts, life insurance proceeds, etc.). That may be the opposite of what you want.

The new law allows you to change this for the better. Beginning next year, you will be able to leave a home worth up to $1 million directly to your kids with no federal estate tax due. You can then generally leave an unlimited amount of other assets (including all the liquid assets) to your spouse estate-tax-free. That way, he or she will have cash for living expenses. And your spouse can always continue living in the house by renting it from the kids. Meanwhile, giving the house to your kids gets an appreciating asset out of your estate and your spouses estate too. Finally, the basis of the home will be stepped up to its date-of-death fair market value which means your children can later sell it with minimal or no capital gains taxes due. The exact same considerations apply if you own a valuable vacation home.

  What About That Basis Step-Up? 

Contrary to what some believe, the current-law basis step-up privilege for most inherited assets will continue unchanged until the estate tax is completely repealed in 2010. So, if you pass on before then, your heirs basis in an inherited asset will generally equal its date-of-death fair market value instead of your probably much-lower historical cost basis. The basis step-up is taxpayer-friendly, because it means an inherited asset sold shortly after your death wont trigger a substantial capital gains tax bill for your heir, even if your basis was tiny in comparison to current value. (Tax-deferred retirement accounts are a notable exception to the basis step-up rule.)

Once the estate tax is completely repealed in 2010, the basis step-up privilege will be partially repealed. Specifically, non-spousal heirs in total will be entitled to a basis step-up of up to $1.3 million. Spousal heirs will be entitled to a basis step-up of up to $4.3 million (assuming they are allocated the $1.3 million step-up plus an additional $3 million step-up available only to them). So, in 2010 and beyond (assuming Congress actually lets the estate tax stay repealed), there wont be any federal estate tax and the partial basis step-up will still wipe out any federal capital gains tax in many cases. Heirs of relatively large estates (the Bill Gates of the world) might owe some capital gains taxes when they sell inherited assets, but generally at only a 20% rate (or whatever the current rate is at that time). Thats a huge improvement over the tax results under the old system.

  Conclusion 

We hope this article answers some of your questions about the new federal estate tax law. Please give us a call for more details. As you can see, your estate plan probably needs some changes to benefit fully from all the changes. We are ready to help you tackle the job.