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Avoiding The Estate Tax Trap

DISCLAIMER: The purpose of this article is to provide general information which is subject to change and is specific to state law. The author and ReliaQuote are not providing legal advice. If you have a specific legal issue, you should consult a lawyer who is licensed to practice law in your jurisdiction.

The federal estate tax is one of the biggest taxes most American's will ever face. Current estate tax rates span between thirty-seven percent (37%) and fifty percent (50%). The IRS provides relief from federal estate taxes in the form of the estate tax exemption. The exemption is currently One Million Dollars ($1,000,000) and is scheduled to increase to One Million Five Hundred Thousand Dollars ($1,500,000) on January 1, 2004, and to Two Million Dollars ($2,000,000) on January 1, 2006. Every person is entitled to an exemption, which means not only can each person pass that amount estate tax free to their beneficiaries, but because married couples are entitled to use two exemptions, one for each spouse, they can pass the value of two exemptions estate tax free. In theory, this means that a married couple can protect Two Million Dollars ($2,000,000) now and will be able to protect even more in future years. Unfortunately, a huge percentage of married couples are on track to waste one of their $1,000,000 estate tax exemptions, which will cost their beneficiaries hundreds of thousands of dollars! Why is this?

If under a married couple's estate plan (or lack thereof), all of the assets on the death of the first spouse pass to the surviving spouse, there will be no estate tax, assuming the surviving spouse is a U.S. citizen. This is because you can pass an unlimited amount to a surviving U.S. citizen spouse estate tax free. However, on the second death, the entire estate will be included in the survivor's estate and will be protected only by the survivor's estate tax exemption. The exemption of the first spouse to die was forfeited when he or she passed everything to the surviving spouse. Now everything over $1,000,000 will be taxed as follows:

Value of total estate: $2,000,000 Value of exemptions used: $1,000,000 Amount subject to estate tax: $1,000,000

Resulting estate tax bill: $435,000

Under this scenario, instead of protecting both exemptions amounts (i.e. $2,000,000) and being able to pass their entire estate tax free, only one exemption is used and $435,000 is wasted in unnecessary estate taxes. How can you protect both of your estate tax exemptions and avoid making this mistake?

Through the help of an estate-planning attorney, you can create a plan whereby you provide for your surviving spouse with all of your assets. But you do not do so by making an outright distribution to him/her upon your death, which would result in the forfeiture of your exemption amount. Instead, you will keep your estate tax exemption in a trust, called a by-pass trust. You will designate your spouse as the beneficiary of the by-pass trust during his or her lifetime and name the beneficiaries who shall receive the assets upon his or her death. You can even name your spouse as the trustee of this trust, thereby keeping him or her in control of the assets. By separating these assets from your surviving spouse, you make them available to your spouse, but ensure that they pass free of his or her estate upon his or her death. The estate tax computation with this plan is as follows:

Value of total estate: $2,000,000 Value of exemptions used: $2,000,000 Amount subject to estate tax: $0

Resulting estate tax bill: $0

This planning preserves your ability to utilize both exemptions and results in estate tax savings of $435,000 given the current exemption amounts and tax rates. Furthermore, as the exemption amount grows, the estate tax savings of this plan grows.

See an estate-planning attorney to learn how you can obtain this protection.

This article was written by C. Daniel Vaughan, Esq. C. Daniel (Dan) Vaughan is an estate planning attorney with the law firm of Vaughan, Fincher & Sotelo PC in McLean, Virginia . He is licensed to practice law in Virginia and other members of his group are licensed to practice in Virginia , Maryland and the District of Columbia . The group is focused on developing and administering comprehensive estate plans tailored to individual needs and circumstances. Dan can be reached at (703) 506-1810 or by e-mail at dvaughan@vfspc.com.