Of Man's Estate

By Dan Kadlec

You may have heard whispers about a movement in Congress to eliminate the so-called death tax, the amount the Federal Government lifts from your estate before heirs get what's coming to them. Nice thought. Estate taxes can be whoppers. The maximum rate--on estates over $3 million--is 55%. Even the lowest rate is stiff: 37% on everything you're unable to shelter.

Estate taxes are essentially a levy on savings that have already been taxed, triggered by the money passing from one generation to the next. That smacks of double taxation, and Republicans have said they'd like to put an end to the practice. But it's doubtful that any bill to that effect will survive this year. Any such change would be viewed as a tax break for the millionaire set. Washington insiders say President Clinton would veto it in a heartbeat.

So whether you're planning your estate or helping Mom or Dad, you may as well figure on the strategies out there. Remember, bad planning can turn a $3 million estate into ready cash of just $200,000.

Say you leave behind $1 million in real estate and $2 million in an IRA. The estate tax comes to about $1 million, allowing for standard deductions and exemptions. But your estate will owe an additional $800,000 right away if heirs take the IRA as a distribution rather than leaving it intact to continue growing tax free. What might force such a distribution? If no beneficiary is named on the IRA and you are past age 70 1/2 at the time of death, it automatically gets liquidated, with taxes due. But even if you've named a beneficiary, he or she might need a distribution to pay the $1 million estate tax. Remember, the only non-IRA asset in this case is illiquid real estate. Result: $1.8 million of a $2 million IRA goes to the taxman. A small part of that may ultimately be recovered through various deductions. But poor planning can devastate an estate. No question about it.

There are three broad areas of estate planning: trusts and gifts to reduce an estate, planning distributions from IRAs and other retirement accounts to minimize the tax, and basics like a will. Let's take them in reverse order.

It's worth noting that 97% of the population will never owe a dime in estate tax. The lifetime exemption this year and next is $675,000 per person and goes to $1 million in 2006. Married couples can easily shelter twice that amount--sums most people only dream of. Meanwhile, virtually everyone can benefit from a written will, a living will and a durable power of attorney. With each, the idea is to keep potential disputes out of court, where legal costs eat into your heirs' good fortune.

"Most wills are too simple," warns Martin Shenkman, a New York tax attorney and estate planner. "You should ask 'what if' to the point you don't care anymore." Who gets what in the event of a child's death or divorce is a key consideration. A living will designates someone to make health-care decisions should you become unable to. A durable power of attorney designates someone to make legal and financial decisions should you become unable to.

These documents are essential to any estate plan. But think twice before giving one of your children durable power. That grants the authority to do things like change IRA beneficiaries. If two children fight and only one has durable power, the other could get cut out. Grant joint durable power, or go outside the family.

IRAs are emerging as the most important part of estate planning. At retirement, many baby boomers will have worked most of their lives for employers with 401(k) plans or similar tax-deferred programs like Keoghs and 403(b)s--many swollen from a long bull market. Typically, the proceeds from such plans get rolled into IRAs when you change jobs or retire. In many cases, IRAs account for 60% to 80% of an estate.

The good news is that IRAs, so tax efficient during your lifetime, can be tax efficient for heirs too. Properly handed down, an heir can stretch out mandatory distributions over his or her remaining lifetime, giving the savings an additional 40 or 50 years to grow tax free. "The key is to pass IRA savings on to heirs intact so the money keeps growing long after you are gone," says Ed Slott, editor of Ed Slott's IRA Advisor. The travesty, Slott says, is that many estate planners are well versed in how to handle real estate, a family business, stocks and bank deposits but know very little about IRA distributions. "Bank tellers do most of the estate planning in this country," Shenkman chimes in. "People just don't appreciate how important these issues are."

First, make sure you've designated a beneficiary on every IRA account. That's not enough, though. Keep copies. You can't rely on a financial institution to have documents 20 or 30 years after an account was opened. Decades of bank mergers have resulted in lousy financial records throughout the system. If you fail to name a beneficiary or if no one can prove that you did, your IRA may be liquidated and taxed. Then the proceeds can be added to the estate and taxed again--as in our opening example.

You also want to make certain that heirs have the means to pay the estate tax without taking an IRA distribution. If the estate does not include enough liquid assets to cover the tax bill, consider a life-insurance policy that pays when the second spouse dies. That's when the bulk of your estate gets handed down. Such a policy should be put in the heir's name and funded through annual tax-free gifts.

Elementary, of course, is that married couples should take full advantage of the lifetime exemption--that one-time $675,000 exclusion from estate taxes mentioned above. For non-IRA assets, you may need a credit shelter trust to divide assets. But if the bulk of your estate is IRA savings, simply divide the IRA money into two accounts--one for the full value of the lifetime exemption and the other for what remains. Generally, you should let the smaller IRA pass to heirs at the death of the first spouse, using that spouse's lifetime exemption. When the surviving spouse dies, heirs get the second IRA, using the second spouse's lifetime exemption. If the second IRA is greater than the lifetime exemption, that's where a second-to-die life-insurance policy kicks in to cover the estate tax. Generally, the policy should be for about half the value of the second IRA.

For more complicated estates there are more complicated solutions. The goal in each case is to get assets out of your estate, driving the estate value as close as is practical to the lifetime exemption. The easiest way is through annual gifting. Married couples can give away up to $20,000 a year ($10,000 for singles) tax free to as many people as they like. Paying tuition is tax free and does not count against the annual gift limit. If you have highly appreciated stock, that can be given to charity at market value, and the charity does not pay tax on the embedded capital gain.

If you own a lot of stock that you expect will rise a great deal before you die, consider gifting the stock up to the annual gift limit. "Do it early, before the value goes up," says Karen Goldberg, a tax lawyer with accounting firm Grant Thornton. "That way you keep future appreciation out of your estate."

Here are three other common ways to reduce your estate:

QUALIFIED PERSONAL RESIDENCE TRUST This lets you get a primary residence or vacation home out of your estate. You place it in trust but retain the right to live there for a set number of years. After the term expires, you presumably move to Florida. But you can also elect to rent the house as long as you like. You must survive the original term, though, or the house gets thrown back into your estate. The advantage: when you set up the trust, it amounts to a gift at discounted value. A $1 million house in a 10-year QPRT counts only as $379,320 against your lifetime exclusion. The discount applies because heirs who receive the house don't get to use it for 10 years.

GRANTOR RETAINED ANNUITY TRUST This lets you fund an annuity that will pay you at a market rate, but with any excess returns remaining in the trust and passing to heirs outside your estate. A typical example would be someone planning to sell a family business within five years. You set up a GRAT with low-priced pre-sale stock. The GRAT pays you back the equivalent of about 8% a year, based on current rates. But actual returns are likely to be far higher when the company is sold. The excess returns stay out of your estate.

FAMILY LIMITED PARTNERSHIP This lets you give away assets at a discount, making your annual gifts or lifetime exclusion go further. A typical example would have you place shares of a family-owned business in the partnership and then give away shares of the partnership. But flps can hold any asset, including publicly traded shares. Just retain full control of the partnership with sole discretion over when to sell any assets held by the partnership. The irs then discounts the value of the assets in the partnership by up to 40%, as they are illiquid to the general partners. In this way, a married couple could gift, say, $20,000 of partnership stock (staying at the annual tax-free gift limit) with an underlying value of $28,000. Good deal.

Thinking about death is painful. But you can lessen the pain for your heirs if you think of ways to beat the taxman now.