Your gross estate comprises all property you own outright or in which you have any type of interest. This generally includes insurance proceeds in which you held any incidents of ownership; IRAs and qualified plan proceeds; certain gifts; and any type of right to control property. Generally, the beneficiary's cost basis of property received from an estate is its fair market value at the date of death. However, for traditional IRAs, qualified plans and annuities, the beneficiary takes the decedent's cost basis (and not the fair market value at the date of death).
The "Applicable Credit" and the Marital Deduction
Two of the most important concepts to keep in mind when tax planning for your estate are the "applicable credit" (formerly known as the Unified Credit) and the marital deduction. The applicable credit will offset tax due on an estate or lifetime transfers of up to the applicable exclusion amount.
For individuals dying and for bequests made in 2009, the applicable exclusion amount is $3,500,000. This allows you to transfer ownership for $3,500,000 worth of assets to individuals other than your spouse without incurring federal gift or estate tax. All estate property that is transferred to a surviving spouse is eligible for the marital deduction. This allows an unlimited federal gift tax-free transfer of assets to a surviving spouse.
For 2009, and for years thereafter, the applicable exclusion will continue to change as follows:
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However, the repeal of the estate tax is only in effect for the year 2010 and must be reenacted to continue, presumably under a different congress and president. This uncertainty in the future of the estate tax laws makes estate planning an important ongoing concern.
One strategy that can be used in 2009 to maximize the benefit from the applicable credit and marital deduction is to give $3.5 million to a non-spousal beneficiary (e.g., children) and give assets in excess of the $3.5 million to the surviving spouse. If the surviving spouse dies in 2009, another $3.5 million worth of assets may pass federal estate tax-free to your children. This strategy will result in up to $7 million cumulatively passing to non-spousal beneficiaries with no federal estate tax liability. As a result, the amount of the applicable exclusion amount depends on the year of death or lifetime gift. Strategies may vary greatly depending on the size of the estate. Consult your tax advisor for a strategy that works for you.
A similar strategy is to create a credit shelter trust. For deaths occurring in 2009, $3.5 million of the decedent's estate is transferred to the trust, providing income to the surviving spouse for life and utilizing the applicable credit. At the surviving spouse's death in 2009, the assets are transferred to the beneficiary of the decedent's choice. The assets in the credit shelter trust are not included in the surviving spouse's gross estate. In addition, appreciation on these assets is not subject to federal estate tax. Accordingly, both spouses' applicable credit will be utilized, and at least $7 million cumulatively will escape federal estate taxation. Credit shelter trusts can be funded either upon death or during your lifetime. Growth assets placed in a credit shelter trust during your lifetime increase the value of the assets that can grow outside your estate.
Life Insurance
Life insurance is generally considered to be one of the most basic and fundamental aspects of any financial plan. A policy that offers life insurance protection for your beneficiary with an element of cash accumulation is a whole life policy; a policy that offers life insurance for a term of years with no cash accumulation value is a term policy. Here are a few of the benefits that a whole life policy can provide:
- Tax-deferred growth: Cash value accumulation in a whole life policy is free of current federal, state, and local income taxes.
- Taxation of proceeds: Amounts received by a beneficiary upon the insured's death are free from current federal income tax.
Policies can be purchased with the basic purpose of providing your heirs with income at death or can be structured to assist with the payment of estate taxes due at death. However, if the life insurance policy is owned by you, it will be part of your gross estate and subject to estate taxes. To prevent this result, consider having an irrevocable life insurance trust own the policy, as discussed below.
Second-to-Die Life Insurance Policy
You can use life insurance to "create" an estate or to preserve its value after estate taxes. To do this, you can consider a second-to-die life insurance policy. "Survivorship" or "second-to-die" policies have become popular since the enactment of the unlimited marital deduction and the opportunity it created to defer the payment of all estate taxes until the death of the second spouse. These policies provide liquidity to pay estate taxes when liquidity is needed most-at the death of the surviving spouse.
Irrevocable Life Insurance Trusts (ILITs)
You can create and fund an ILIT with annual gifts to the trust, thereby maximizing the benefits of the annual gift tax exclusion ($13,000 for 2009). The gifts will also help to reduce your estate. Using your gifts to pay the premiums, the ILIT purchases life insurance on your life. The trust becomes the owner as well as the beneficiary of the life insurance policy. At your death, life insurance proceeds are paid to the trust as the contract's beneficiary. The trust can use the proceeds to purchase assets from or make a loan to your estate. The executor uses this cash to help pay estate taxes and expenses. The assets purchased by the trust may then be distributed to the trust beneficiaries-your heirs.
Lifetime Asset Transfers
You may give a tax-free gift through the annual exclusion. This allows you to give up to $13,0001 per year per beneficiary. If you are married, your spouse is entitled to a separate $13,000 exclusion, which means a husband and wife can give $26,000 to each person annually, free of federal gift and estate tax, if they elect to split the gift.
If the fair market value of the gift exceeds the amount of the annual exclusion, the excess reduces the amount of your applicable credit. The gift tax applicable exclusion amount is currently $1 million and remains at that level going forward. If you use a portion of the applicable credit toward lifetime gifts, less value may be transferred federal estate tax-free at death. On the other hand, all income and appreciation of assets properly transferred during your lifetime are removed from your taxable estate. Gifts to a spouse are eligible for the gift tax marital deduction. This allows unlimited federal estate tax-free gifts to a spouse without reducing the applicable credit.
Gifts in excess of the applicable credit are subject to federal gift tax. These tax rates are the same as estate tax rates and are based on the fair market value of the asset transferred on the date of the transfer. In 2010, when estate tax is repealed, the gift tax rate is scheduled to be 35%, which is the top income tax bracket.
In addition, the direct payment of medical or tuition expenses on behalf of another person is considered to be a federal tax-free gift. These direct payments are not included in determining the amount of the annual exclusion.
Gift and estate tax planning can be highly complex on both the federal and state levels. It is suggested that you seek the advice of a tax advisor or an attorney specializing in this area.
Strategic Gifting to Individuals
You may significantly reduce the size of your gross estate through annual gifts of the exclusion amount ($13,000 per donee for the year 2009). Married couples filing jointly may elect to split gifts and convey up to $26,000 per donee ($78,000 total to three donors, for example). In addition to the annual exclusion, you may also gift up to the applicable credit amount and thereby remove future appreciation from your gross estate.
Gifting assets during your lifetime also removes from your gross estate all future appreciation on the asset gifted. As a result, you may reduce your potential federal estate tax. Be sure to select the appropriate asset (for tax purposes) to gift. You may realize income tax benefits by transferring any unrealized appreciation in the gifted asset to the individual, who may be taxed at a lower rate
You cannot transfer the unrealized loss in any asset that has decreased in value. In such a case, neither the donor nor the recipient can benefit from the tax loss. The donor may, however, sell such an asset, recognize the tax loss, and gift the sales proceeds.
Strategic Gifting to Charities
You may donate securities to a charity either during your lifetime or upon death. Donating appreciated assets held for over a year has several tax benefits:
- You qualify for an income tax deduction based on the fair market value of the assets on the day of the transfer, subject to certain percentage limitations.
- You do not pay income tax on the asset's appreciation.
- You transfer the value and future appreciation of the gifted stock out of your estate.
Life Insurance is issued by The Prudential Insurance Company of America, Newark, NJ, and its affiliates. Like most insurance policies, our policies contain exclusions, limitations, reductions of benefits and terms for keeping them in force. All guarantees are based on the claims paying ability of the issuer. Your Prudential financial professional can provide you with costs and complete details. Each Prudential Financial company is solely responsible for its own financial condition and contractual obligations.
1 For 2012. This figure is subject to adjustment for inflation.