The federal estate tax is a tax on your right to transfer property at your death. The tax is imposed on the value of everything you own, less any exemption that is in force at the time of death. In 2009, the federal exemption is $3.5 million per person. If the value of a decedent’s property exceeds the exemption, the excess amount is subject to a tax of up to 45 percent.
For many years, the first $1 million in assets of a decedent were exempt from taxation. Although $1 million is a very large amount of money, a $1 million exemption limit created massive problems for families that owned land, farms or small businesses. If the majority of a decedent’s wealth consisted of real estate or a business instead of more liquid investments, families were often forced to sell assets that had been in the family for generations, just to raise cash to pay the estate tax.
In 2001, to accommodate growing property values, Congress enacted legislation that gradually increased the exemption, lowered the maximum estate rate from 55 percent to 45 percent, and, at least temporarily, eliminated the estate tax altogether. By 2009, the federal exemption grew to $3.5 million, and unless Congress amends the law before the end of this year, there will be no federal estate tax due on the estate of a person who dies in 2010. If the law remains unchanged, the exemption is due to return to $1 million in 2011, and the top estate tax bracket will return to 55 percent.
Before the government’s massive bailout of the financial markets, it was widely expected that Congress would make the $3.5 million exemption permanent. Now, that expectation is unrealistic. With only a few weeks left until Jan. 1, it’s likely Congress will enact a “patch” to extend the 2009 limits for one more year, until a more permanent plan can be developed. Whatever the eventual exemption limits will be, most analysts expect that some form of estate taxation will remain.
Individual estates may also impose their own estate taxes, with exemptions that may or may not be based on the federal limits.
Life insurance has long been used as an estate planning tool. In addition to providing a death benefit to replace the loss of a wage-earner’s income, life insurance is frequently used to help pay estate taxes. In order to avoid subjecting the life insurance proceeds themselves from estate taxation, estate planners often use irrevocable life insurance trusts (ILITs).
Following is a very simplified explanation of the typical way an ILIT works: Generally, the first step is to create the trust, and name a trustee. The trust purchases a life insurance policy on the life of the person who creates the trust (the grantor). The trust becomes the owner and the beneficiary of the policy. Each year, the grantor makes a gift of cash to the trust, which the trustee may use to pay the life insurance premium. At the death of the grantor, the life insurance proceeds are paid to the trust. The terms of the trust state how the death benefit is to be distributed. If the trust has been properly created, the death benefit does not become part of the grantor’s estate, and the proceeds may be used to either pay any estate taxes that might be due on the grantor’s other assets, or paid to his or her heirs.
Regulations permit an existing life insurance policy to be transferred into an ILIT, but the policy’s death benefit will be included in the grantor’s estate if death occurs within three years of the transfer. It is essential to change both the owner and beneficiary of the policy to the trust to avoid inadvertently failing to remove the proceeds in the grantor’s estate.
With so much uncertainty about the existence or extent of future estate taxes, ILITs continue to be popular estate planning vehicles. In order to fully benefit from this strategy, you must be especially diligent to comply with strict rules about the language of the trust, the selection and powers of the trustee, the procedure and documentation of gifts to the trust, and other constraints. For this reason, it is especially important to work with a competent and experienced estate planning attorney.
Elaine Morgillo is a Certified Financial Planner and president of Morgillo Financial Management Inc. She has offices in Portsmouth and North Andover, Mass., and can be reached at emorgillo@morgillofinancial.com
In Lafayetta, LA contact Andrew Ahrems at:
http://www.ahrensinvptr.com/new/ahrensinvptr/