What Is the Federal Estate Tax?
The tax your estate might owe when you die is technically a transfer tax. You pay tax on the right to transfer your assets to another person or institution. Taxable gifts made during your lifetime are added to the transfers you make when you die to determine a taxable base. The taxes your estate owes at your death are a percentage of your taxable base if your taxable base exceeds the unified credit amount. Confused? Don't worry, keep reading.
Unified Transfer Tax
The federal estate tax is not a stand-alone tax. In 2001, Congress made changes to the way federal estate taxes are computed. It divided the taxable transfers into two pieces — one for gifts and one for estates. The first piece covers taxable gifts you make during your lifetime. The second piece includes taxable transfers you make at your death. The IRS requires you to add gifts and transfers at death together. The total of the two transfers are subject to what the IRS calls a “unified transfer tax or unified credit.”
You are required to file gift tax forms for gifts exceeding the annual exclusion, currently $13,000, or the lifetime exclusion (other than gifts to your spouse), currently $1 million. You must keep track of all the taxable gifts you make during your lifetime. At death, the records you've kept will assist your executor in determining how much of the unified credit remains.
The easiest way to understand the unified transfer tax is to think of it as a savings account. The federal government grants you a savings account of a dollar amount that is exempt from taxation. The dollar amount on which no taxes are due includes two exclusions. There is a gift tax exclusion amount and a unified credit exclusion amount. These amounts are not the same, and the gift exclusion is a subset of the unified credit amount. You can use the gift tax exclusion to shelter gifts or transfers while you are living, and you can use the unified credit exclusion to shelter transfers you make at death. Continue reading for further details.
Savings Account or Unified Credit Amount
Congress has changed the savings account amount over the last fifteen years. In May 2001, Congress increased the exclusion from $675,000 per person to $1 million per person for both gifts and estate transfers. For example, suppose that your savings account in 2002 was $1 million. If you made a taxable gift of $300,000 while you were living, you had $700,000 of savings or exclusion remaining at your death.
However, Congress then changed the exclusions for several subsequent years and separated the gift and estate transfer amounts. In 2009, the gift tax portion will be $1 million, but the unified credit for both gifts and transfers at death will be $3.5 million per person. Let's take an example of a gift in 2009.
You give your son $513,000 and your daughter $513,000. As you have just read, you are allowed to give $13,000 annually without tax, but any gift exceeding $13,000 is a taxable gift. Therefore, in this example, you subtract $13,000 from your gifts to each child. The balance of $500,000 to each child is taxable. You have made taxable gifts of $1 million ($513,000 plus $513,000 minus $26,000). Later in 2009 you die. Your executor calculates your taxable base of all other assets as $2 million.
If you have made prior gifts to your children, in excess of the annual exclusion of $13,000, those gifts will be included as part of your taxable gifts. If you have made gifts during your lifetime to your children exceeding $1 million, the amount in excess of $1 million will be taxed even if your total estate is less than $3.5 million.
Because the total exclusion in 2009 is $3.5 million, you first subtract your taxable gift of $1 million leaving a savings account or unified credit of $2.5 million. Because your gifts did not exceed the $1 million gift tax exclusion, there is no tax owed on your gifts to your son and daughter. And, because your estate, which the executor calculates at $2 million, is less than your remaining unified credit total of $2.5 million your estate will not owe any taxes.
In the year 2010, according to the present schedule, there will be no estate tax, but there will continue to be a gift tax. The highest tax rate on gifts in 2010 will drop from the 2009 rate of 45 percent to 35 percent. If you die that year, you will be able to transfer your estate property at death and pay no transfer taxes.
To complicate things even further for you and your family in your planning, in 2011 the savings account or unified credit amount is scheduled to revert to a unified exclusion of $1 million, which was the figure in place for many years prior to the 2001 Tax Act. The highest tax rate will jump back up to the former 55 percent rate.
Congress frequently changes the tax rates and rules when they figure out that the tax breaks they provided cost the government too much in lost revenue. Pay attention to future changes to the rates and unified credit, as changes could well affect your well-thought-out plan.
What follows in 2011 or beyond is still uncertain. Congress makes estate planning difficult by periodically changing the rules! You or your heirs can plan only on the unified credit in effect in the year of your gift or of your death.
