What You Need to Know About the Estate Tax

The answers to 4 common questions about the impact of the new law.

By + More

The holiday gift from Congress of highly favorable estate tax law changes may impact you and your family. Learn what the new rules are and whether you need to take action now.

[In pictures: 10 Ways to Improve Your Finances in 2011.]

1. What are the federal estate tax rules through 2012?

For those who die before 2013, there is a $5 million exemption amount. This means someone dying with an estate consisting of assets valued up to $5 million will have no federal estate tax.

Even larger estates can pass tax free. There continues to be unlimited marital and charitable contribution deductions. For instance, if you have an estate of $6 million and you leave $1 million to charity, there is no estate tax; the $5 million exemption amount plus the $1 million donation shield all your assets from taxation. The Tax Policy Center estimates that there will be only about 3,600 taxable estates in 2011.

There is a new concept, called “portability,” that married couples can rely on to increase their tax savings. If any part of the exemption amount is not used by the first spouse to die, the surviving spouse’s estate can use it. Say you die and only use $3 million of your exemption amount; your spouse now has an exemption amount of $7 million (her $5 million plus the $2 million that you didn’t use).

If part of your estate is taxable, the rate is only 35 percent—the same maximum tax rate for income tax on individuals and regular corporations. The estate tax rate in 2011 had been scheduled to be 55 percent.

Assets inherited before 2013 enjoy a “stepped-up basis” for income tax purposes, so that the heirs’ basis is the property’s value for estate tax purposes. Say you purchased stock years ago at 50 cents a share that is worth $5 per share when you die. Your heir’s basis in the stock is $5 per share; no one will ever pay any capital gains on your appreciation in the stock up to the date of death.

2. Do I still need to plan?

Probably yes. The favorable federal estate tax rules run only through 2012. No one knows what will be after that. For those with large estates, it’s advisable to work closely with a professional planner to devise plans that can be adapted if and when future tax rules change.

What’s more, even if you do not face any federal estate tax now, there could be an estate tax or inheritance tax on the state level. About half the states continue to impose their own taxes, often with much more modest exemption amounts. For example, New Jersey continues to have an exemption amount of only $675,000, so planning can be helpful to reduce or eliminate state-level taxes.

Even if you have not tax concerns, you need to make plans for special situations, such as children, especially in second marriages, and business interests.

[Visit the U.S. News My Money blog for the best money advice from around the web.]

3. What about my existing will?

If you signed your will before this year, you probably should have it reviewed by an attorney to make sure your wishes continue to be actualized in light of tax law changes. Problems can exist with older wills that were crafted with a much lower exemption amount in mind.

Take this case: When you wrote your will, you were married and had an estate of $5 million; the federal exemption amount at that time was $2 million and you included a trust that was to be funded with the maximum exemption amount. At that time, $2 million would have gone into the trust tax free; the other $3 million would have passed tax free to your spouse. Without any changes, if you die before 2013, all of your property will go into the trust and nothing will pass outright to your spouse. Is this what you wanted?

Don’t be quick to turn your back on the use of trusts. Even if no longer needed for tax savings, they still serve important non-tax functions, such as property management and keeping assets from heirs’ creditors.

4. My dad died in 2010, so what happens to his estate?

For estates of those who died in 2010, there is a special option: Use the new estate tax rules, combined with the stepped-up basis rule for heirs or use the rules that had been scheduled for 2010.

The 2010 rules that were to apply: no federal estate tax, regardless of the size of the estate, but a modified carryover basis for heirs. Under this carryover basis rule, up to $3 million in assets passing to a surviving spouse, plus $1.3 million passing to anyone, gets a stepped-up basis. Assets over these limits have a carryover basis, which means the heirs essentially step into the shoes of the decedent and take his or her basis. In the earlier example, carryover basis means an heir’s basis is 50 cents per share (what the decedent paid for the stock), rather than the stock’s value at death of $5 per share.

As a general rule, estates over $5 million would use the old rule to avoid any estate tax, while smaller estates would use the new rule to give heirs the better basis. Best strategy: Work with a tax professional to decide which option is better for your family.

Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser’s 1001 Deductions and Tax Breaks and The Complete Idiot’s Guide to Starting a Home-Based Business. She is also the publisher of Idea of the Day and monthly e-newsletter Big Ideas for Small Business at www.barbaraweltman.com and host of Build Your Business radio. Follow her on Twitter @BarbaraWeltman.