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How Do I Take Advantage Of The 2010 Federal Estate Tax Repeal

Benjamin Franklin once famously wrote, "In this world nothing can be said to be certain, except death and taxes." American humorist Will Rogers followed it up by saying, "The only difference between death and taxes is that death doesn't get worse every time Congress meets."

Both men might be surprised to learn that their statements aren't entirely true, at least this year. Federal estate taxes are no longer certain, and for some families whose loved ones die in 2010, the repercussions could compound their grief at the passing of their loved one.

Unless Congress acts to amend the current law, for the first time in 2010, anyone dying will not be subject to federal estate taxes. This may sound like terrific news, and for some people it will be. But others may find that the change in estate taxes this year has unanticipated and unintended consequences.

How did this happen, and how can individuals plan for an uncertain tax future? The answer to the first question lies in the behind-the-scenes deal making that accompanied the Economic Growth and Tax Relief Reconciliation Act of 2001.

Congressional Action and Inaction

Republicans in Congress have long favored eliminating the federal estate tax, and in 2001 (when they controlled Congress) they passed a bill which gradually reduced the estate tax burden each year until 2010, when it eliminated the tax entirely. To get the bill passed, though, they included a "sunset" provision which stipulated that (unless Congress acted) the tax would return to its 2001 level in 2011.

Because of the drastic changes which would occur in 2010 (no tax) and 2011 (high tax rates that hadn't been seen in a decade), most observers expected Congress would act in 2009 to extend the then-current estate tax rates (45% tax on estates over $3.5 million) into 2010, and possibly beyond. But although the House of Representatives passed a bill to do just that, the Senate failed to take up the bill before the end of the year and thus, for the moment, there is no estate tax.

Complications for Some

Although this sounds great, it may have far-reaching complications because of how some wills are written. A common provision in wills is to designate that the non-taxable part of the estate go to the deceased person's children or other beneficiaries, while any amount over that (which is generally taxable) pass to either the surviving spouse or to a charity. Generally, this allows the entire estate to pass to others withoutbeing reduced by federal taxes, because bequests to spouses and charities are never subject to the estate tax.

But in 2010 when there is no estate tax, all of the estate is non-taxable. That leaves no "taxable" portion to go to a spouse or charity. Thus a widow could discover that her husband's entire estate passes to his children, and nothing passes to her.

Because many wills have been drafted with the language which grants the taxable part of the estate to one beneficiary and the rest of the estate to another, now is a good time to review your will with an attorney, who can amend your will to clarify your intentions.

Consider Gifts

In 2010, the tax rate for gifts above $13,000 is 35 percent, down from 45 Percent last year. Congress could change the rate for 2011 and beyond, or it may allow the 2001 levels to return. Further complicating matters, some predict that Congress will try to make any changes for 2011 retroactive to 2010, as well. In any case, many expect rates will rise to 45 percent or even 55 percent next year, which means that 2010 will likely be the best year for transferring wealth to loved ones.

Because of the uncertainty about future Congressional actions, some financial planners are setting up special trusts for their clients which allow a spouse to either accept the money (as a non-taxed spousal gift) or to disclaim the money and allow it to pass to grandchildren, depending on which situation will best avoid taxes after Congress acts.

Other Taxes May Still Apply

Although 2010 looks to be an excellent year for saving on federal taxes, other taxes may still apply. New Jersey imposes its own estate taxes on estates valued over $675,000, at a progressive rate ranging from 4.8 percent up to 16 percent for the largest estates. New Jersey also taxes inheritance, so the recipient can be subject to taxes.

Furthermore, some inherited investments may be subject to capital gains taxes, which tax the increase in value of investments at the time they are sold. For example, if someone inherits shares of stock that were purchased for $20 per share and valued at $50 at the time of inheritance, then later sells the shares at $60 per share, usually only the increase in value of $10 since inheritance is subject to capital gains taxes. But for amounts over $1.3 million, the full $40 per share increase is subject to capital gains taxes. In some cases, this capital gains tax is greater than the inheritance tax would have been if it had been in effect in 2010.

Right now, no one is certain what will happen next-after all, most experts agreed in late 2009 that Congress would act to prevent the current situation from happening in the first place. Although in 2009 only a quarter of one percent of estates were valued at over $3.5 million and were thus large enough to be affected by the federal estate tax, if the 2001 rate returns, it will affect any estate over $675,000-a much more substantial portion of the population.

It's a good idea to review estate plans from time to time, and the situation with the federal estate tax laws in 2010 is a vivid reminder that wills and trusts drawn up years ago may not be appropriate today. Talk to an experienced estate planning attorney who understands how the federal and state laws can affect your plans for your spouse and other loved ones.