December 13, 2005

In terms of changes, the federal estate rules are a complex, moving target that will shift again on January 1, 2006. On that date, the federal estate tax exemption will jump from $1.5 million to $2 million and the maximum tax rate will drop from 47 percent to 46 percent. (The exemption will then stay at $2 million until 2009, when it is scheduled to increase again to $3.5 million, assuming Congress does not make any changes.)

As you probably know, under current law, the estate tax is scheduled to be repealed in 2010. But to make matters more complicated, in 2011, the estate tax laws are scheduled to revert to the way things were in 2001, when the exemption was $1 million and the top tax rate was 55 percent. The Senate was supposed to vote on a permanent repeal a couple of months ago, but after Hurricane Katrina hit the Gulf Coast, the Senate canceled the vote.

What should you do now? While the increased exemption for 2006 is good news, you may need to adjust your estate plan accordingly. Even if your estate plan needs no work, you may have an elderly loved one whose plan requires attention.

Bypass Trusts May Need Tweaking

Common scenario: An updated estate plan may be in order if you are married and have set up a bypass trust arrangement in your will or living trust document (bypass trusts are also commonly called credit shelter trusts). The bypass trust’s main purpose is to allow both you and your spouse to take advantage of your respective federal estate tax exemptions.

Typically, assets with value equal to the current exemption amount are automatically put into the bypass trust when the first spouse dies. The trust is created at that time and is irrevocable. The beneficiaries of the trust are designated by the first spouse to die, and the assets used to fund the trust come out of that person’s estate. The beneficiaries are usually that person’s children (or grandchildren).

Since the first spouse to die designates the bypass trust beneficiaries, the assets used to fund the trust are included in that person’s estate for federal estate tax purposes. However, no federal estate tax is due because that person’s exemption provides just the right amount of tax shelter.

The surviving spouse can be given money from the bypass trust to meet his or her reasonable financial needs. When the surviving spouse passes away, the remaining assets in the bypass trust go the beneficiaries of the trust.

Here’s a potential problem: Some wills don’t state a specific value for the assets that will be used to fund the bypass trust. Instead the language effectively says that assets with value equal to the current federal estate tax exemption amount will be placed into the trust. But with the exemption suddenly jumping from $1.5 million to $2 million on January 1st, the bypass trust could wind up with a lot more money than was intended and the surviving spouse could wind up with a lot less than what was intended.

Example: Let's say you have a $2.6 million estate. Your will currently stipulates that a bypass trust is to be funded with an amount equal to the current federal estate tax exemption if you die before your spouse. Your children are named as the trust beneficiaries. If you die between 2006 and 2008, $2 million would automatically be funneled into the bypass trust. Your spouse would get the remainder of your estate, which would be only $600,000 ($2.6 million minus $2 million used to fund the bypass trust). That $600,000 figure may be less than you had in mind. While your spouse can be given money from the bypass trust to meet reasonable financial needs, it doesn’t make any sense to leave the window open for future problems. Worst case: Your spouse could run into a cash crunch and then get into a legal hassle with your kids regarding what can “reasonably” be taken out of the trust.

Possible solution: Revise your will to stipulate a figure to fund the trust if you die before your spouse in 2006 through 2008. For instance, $1.3 million might strike the right balance. That way, half of your estate would go into the bypass trust for the benefit of your children while the other half would go directly to your surviving spouse. With this revised arrangement, your surviving spouse would receive $1.3 million instead of only $600,000.

If you and your spouse have larger estates, you could have the opposite problem of a will or living trust document that does not stipulate that the bypass trust will be funded with the larger exemption amount that will take effect in 2006. In this case, adjustments are needed to take full advantage of the increased exemption amount.

Other Revisions May Be Needed Too

Even if you don’t have a bypass trust arrangement (for example, because you're unmarried), the larger exemption amount that will take effect in 2006 is a good reason to revisit your estate plan. For instance, an increased exemption means you could leave more directly to loved ones and less to charity without any federal estate tax bill if you die in 2006 or later.

For most people, an estate plan is always somewhat of a moving target because of tax law changes and other events that occur in their lives (see right-hand box).. Your estate planning adviser can help you make the right tax-saving moves so that your heirs will get more and Uncle Sam gets less.