Preparing For The Death Tax Debate

This post is part of the one day blog event “The Spectrum of Personal Finance.”  In this event, Brian of My Next Buck, will discuss 8 different emotions and relate them to personal finance.  Here at Free Money Finance we will be looking at Death. To view the rest of the event look at the bottom of the page to see the other blogs hosting articles.

In the coming weeks we are going to hear more and more stories coming from Congress discussing the death tax.  For those that don’t know, the death tax, more appropriately known as the “estate tax”, is a tax on wealth being transferred (i.e. inherited) from one generation to the next upon the death of the owner.  The estate tax has always been dubbed as a tax on the uber rich, but if Congress doesn’t make some changes in the near future, this will be a tax on anyone with taxable wealth of over $1 million beginning in 2011.

Unfortunately, $1 million sure can’t buy what it used to, especially if you plan to retire someday.  It is likely that a lot of us will shoot for nest eggs well over the million dollar exemption by the time we reach retirement, making our wealth eligible to be taxed at an alarming rate of 55% upon our deaths.

Don’t Plan on Dying in 2011

This topic does have a sense of morbidity about it.  It’s really not cool to think about an appropriate time to die.  Then again, with the way the taxes are currently set up, dying in 2009 vs. 2010 vs. 2011 could mean millions of extra dollars in taxes for dependents.  Here are those three years’ exemptions and maximum tax rates:

• 2009 - $3.5 million; 45%
• 2010 – No exemption, 0% (tax repealed)
• 2011 - $1 million; 55%

If an individual with a net worth of $3.5 million dies in 2011 compared to 2010, the individual’s family would pay $1.375 million in additional taxes.  Regardless of your political affiliation, I think it’s safe to say that no one would want to pay an extra $1.4 million in taxes on January 1st 2011 compared to $0 on December 31st 2010.

Why You Should Care

The $1 million exemption limit that will go into effect in 2011 may sound like a fair amount.  After all, a million dollars is a lot of money.  For those that have worked hard and accumulated wealth over the years to afford retirement, and for those that have helped their parent’s estate plan, this could mean that a bulk of hard earned money could be going to the Fed’s coffers instead of your family’s.

It’s never too early to worry about these issues.  At the age of 25 I plan on saving, investing, and growing my wealth to a nest egg that greatly exceeds $1 million.  I would hate to put 40 years of work into building my wealth, only to see 55% of anything in excess of $1 million be taken away from my dependents by the government.

If you are a small business owner, you have to be even more concerned as a lot of small businesses get liquidated as a means for families to pay the estate taxes of the deceased.  Speaking of liquidation, if your assets are tied up in real estate and other non-liquid investments, beware that those assets are likely to be sold promptly to pay off these taxes.  Many families lose their businesses and even their homes because the majority of the owner’s assets are not liquid.

What Can You Do About It?

While estate taxes are going to be unavoidable in the future, it’s in the best interest of you and your dependents to take a few steps NOW to minimize the effect of the tax on your wealth.  Here are a few things you can do today to plan for tomorrow:

• Make lifetime gifts (up to the point of hitting a gift tax) – You can give up to $13,000/year per recipient without paying any tax. You can also pay someone’s medical bills, tuition or give to charity without paying tax. This reduces the size of your estate and the eventual tax bill.

• Create an irrevocable trust – These trusts allow you to “remove” ownership of the assets held inside the trust (usually cash, investment assets, a business). Therefore you are technically removing the assets from your taxable estate. Furthermore, the grantor is also relieved of the tax liability on the income generated by the assets in the trust.

• Create a Living Trust with “A-B Provisions” – This trust is complex, but in short, it allows you to pass your estate onto your heirs, while still allowing your spouse to have full access to the funds. The funds will not be transferred to the heirs until the spouse passes. However, the tax bill is for the original amount of the grantor’s estate, which means any appreciation in value of the estate will not be taxed.

• Set up and Transfer a life insurance trust – A life insurance trust exists to own a life insurance policy. If the owner of the policy transfers ownership of a life insurance trust to a beneficiary, the proceeds will be completely free of estate taxes.

• Go see an attorney and an estate planner – This stuff is complicated and an attorney can help you sort through all of the fine print and possibly come up with some more creative ways to mitigate your estate tax liabilities.

Keep an eye out over the coming weeks as the estate/death tax starts to make more news.  It is unlikely we will see a repealing of the tax for 2010, but it is possible that new legislation will be passed that may impact your estate plans.  Pay attention and meet with your financial advisors to ensure that your family is taken care of with or without you.

For further reading of the Spectrum of Personal Finance Event, please see:

• Fear at Bargaineering
• Hope at Budgets are Sexy
• Avarice at Consumerism Commentary
• Willpower at Debt Free Adventure
• Death at Free Money Finance
• Compassion at Get Rich Slowly
• Love at Mrs. Micah
• Rage at Poorer Than You

To view a recap of the event, check out the Spectrum Roundup at My Next Buck

Comments

[Rocky]

I don't understand the death tax. Never have, never will. You pay some form of tax everyday of your working/consuming life, and then your estate gets taxed because you died??

Never will understand this one. 55%. I don't get it.

[Nick]

It isn't really that complicated. You earned the money and your estate is giving that money away to someone that isn't you (because you are dead). It isn't any different than the contestants on The Price is Right having to pay taxes on the prizes that they "earn."

[cmadler]

Think of it as an extension of the gift tax.

If I give someone (not a charity) $1,000,000 tomorrow, there are taxes due, regardless of whether I'm alive or dead.

Off topic, how FMF did you wind up with the one "Spectrum of Personal Finance" topic that isn't actually an emotion?

[FMF]

cmalder --

Luck, I guess. ;-)

[Rocky]

Let me clarify. I "get" taxes. I don't understand the government taking 55% when I die.

Sorry, but nobody can possibly rationalize 55% to me. I mean, seriously - don't they take enough? From all of us?

[Seth]

Rocky,
I don't think you can rationalize 55% because it isn't rational. After the financial bailouts, people turned their anger on the rich; not corporations. What they don't realize is that small businesses may have a large portfolio of assets, but use those assets to generate income for employees, not to pay themselves. What I can't stand is the rhetoric of politicians who say that they support small business and recognize it as the bread and butter of the American Economy and then turn around and stick small business owner's kids with a huge tax bill to continue the business. That's not right. If you're interested in getting involved, I'm a member of Estate Tax Truth, a project of the American Family Business Foundation. I forget their website, but you should check them out.

[craig]

Sounds so complicated and if I am in that situation will head to a lawyer first because this sounds serious and something where you should find someone who fully understands it to work with.

[Michael]

There should be no debate. This tax supplies less than 1% of the federal budget, destroys small businesses and the jobs those businesses were supporting, and line the pockets of large life insurance companies to the tune of $12 Billion a year (which explains why they are spending millions lobbying to preserve the tax.)
Do we need more job killing corporate welfare right now?

[Carlos]

This article has a helpful conclusion. It's too bad that there are errors, omissions, and half-truths in the first part of the article that seem to be causing people to miss the point.

Let's look at one of the errors:

"If an individual with a net worth of $3.5 million dies in 2011 compared to 2010, the individual’s family would pay $1.375 million in additional taxes." (3.5 - 1.0 exclusion = 2.5, 55% of 2.5 is 1.375).

Close, but wrong. You seem to be using the same faulty reasoning used by people who don't understand marginal tax rates. The 55% does not apply to the entire taxable estate. The 55% is the top tax rate on the last taxed dollar.

Going by the Congressional Research Service (http://www.nationalaglawcenter.org/assets/crs/RL33718.pdf) the tax on your example estate in 2011 would be 1.22 million.

As a percent of the totable taxable estate, that's only 35%-- a big difference from 55%. In fact, the average estate pays less than 20% (of the total estate value) in taxes.

Sure, you weren't off by much, only about 150K, but the point is if you can't even get the basics right, how do we know the rest of your facts are accurate?

Here's some more problems:

"...a lot of small businesses get liquidated..." and "Many families lose their businesses ..."

Depends on what you mean by "a lot." The CBO found (http://www.cbo.gov/ftpdocs/65xx/doc6512/07-06-EstateTax.pdf, table 8) that in 2000, only 164 small business estates were not liquid enough to pay the tax liability. Now for those 164 estates, that's a big deal. But relative to the total number of small businesses, I don't see that as a lot. Also, the CBO report does not say if those businesses *had* to be liquidated, those estates might have had other assets that could have been sold to pay the tax.

"Many families lose their businesses and even their homes..."

Huh? Where do you get that families lose their home? They would only lose their home if it was part of the estate. So yeah, if Daddy Warbucks has his three children and 10 grandchildren living under his roof, there is a small possibility that they could lose their home. But in most cases, the grown dependents of the deceased would be living in their own home and their home would not be sold to pay the tax because it is not part of the taxable estate.

And let's not forget that if you have a surviving spouse, no taxes are owed. It's only when the estate passes to children or other dependents that the estate owes tax.

So yes, as the conclusion says, plan ahead for your what happens to your estate when you die. But let's have facts and logic next time, not hyperbole and FUD.

[BillV]

It is rational if you accept the premises it flows from. (I'm not saying you have to accept the premise -- and fairness has nothing to do with it ;-> )

It is a method of income/wealth distribution. Part of the attempt is to prevent wealth being concentrated into fewer and fewer families. Of course another part is just to get the money. After all, what did the receivers of the wealth/estate do to earn or produce the wealth, other than the luck of the gene pool?

Please keep in mind I may or may not agree with what I just wrote lol. Just tryg to provide a "rational" to Rocky.

[jp]

In many cases dying actually provides a pretty good tax break. Large estates commonly consist of investments and real estate. If Grandma sells her million dollars worth of IBM stock that she bought back in the 60's, she is obligated to pay capital gains tax on the appreciation. However, if she holds the stock until she dies, her heirs can liquidate the stock and take the entire million dollars tax free. Grandma's old house gets the same treatment.

[Kirk Kinder]

Obama has apparently agreed to a $3.5 Million cap in 2011, at least that is what has been mentioned. I wouldn't plan on it, but I hope it rises from $1 Million.

@ Nick: this isn't like the Price is Right. If you win on the Price is Right, the prizes have not been taxed yet. You pay an income tax on the value of the goods or services you receive. For the estate tax, the taxpayer has already paid a tax on the assets or income. This is a secondary tax. It would be like paying a tax on the Price is Right prize and then giving it to your kids so they can pay a tax on it as well.

[Apex]

@jp,

That's exactly right. It's called a stepped up basis. And in 2010 when the state tax is eliminated so is stepped up basis. For most estates stepped up basis is more important than the estate tax. The huge ones care more about estate tax but I would venture to bet that 99% of the people reading this would be more impacted by stepped up basis than the estate tax after the exemption.

If you have an estate with lots of unrealized capital gains (stock, real estate, business equity) then if you inherited those assets and wanted to get access to some of the cash you could sell them and the cost basis would be the value at the time of inheritance which would mean zero capital gains tax was due. If you inherit land that was purchased 40 years ago for 1/20th the value it has today and inherit that and have no estate tax but then go to sell it so you can access the capital you would pay the capital gains rate on 95% of it. Currently 15% federal plus your state rate. But I would not be surprised to see that increase to 20 or 28 percent.

For most people that is a much more important factor.

Yes the estate tax is kind of nasty. But it's just not very likely at all that they will ever really get rid of it. And given the choice between having an estate tax exemption of 3.5 million per person (7 million per couple) which is what seems likely to be the compromise point and a stepped up basis provision, or no estate tax and no stepped up basis, I will take the 3.5 million exemption with the stepped up basis in a heart beat.

It's also worth noting that in the 80s the exemption started at 161k and was slowly raised up to 600K by 1987. Clinton tried in the 90s to get it lowered back down to 200k but that failed. Then Bush raised it to 1 million in 2002 and as part of the 2nd tax cut it was raised in increments up to current 3.5 million. It was scheduled to be eliminated in 2010 and then reverting back to the 1 million in 2011.

A 3.5 million exemption in comparison to the 200k or 600k exemptions of the 80s and 90s in inflation adjusted terms is a much higher exemption than we have ever had. It's actually quite a good exemption that will cause very few people to be trapped except for the very wealthy business owner which I admit its a problem for those few people. If they could index it to inflation, the 3.5 million would be a very good number for almost all people acquiring wealth and trying to keep it for posterity.

[StLPastor]

Just a few thoughts-

The US can tax living people, or dead people. The estate targets dead rich people. There is absolutely no better tax in the entire world than a tax on dead rich people (other than maybe a tax on carbon. That would be in the discussion, just for the pricing negative externalities value). The estate tax should be increased.

Why is this a good tax? 1) You can't take it with you. Being taxed while living is annoying. Being taxed while dead, painless. 2) You can't motivate dead rich people through lower taxes, so there is no economic efficiency to be gained by lowering the estate tax. 3) dead rich people can't make sound investment choices to help the country, so the money isn't being used particularly well. 4) persuading living rich people to spend more of their money before they die stimulates the economy and helps charity. Its a win-win from every economic perspective.

The only people the estate tax 'hurts' is children of dead rich people-who have all the advantages of being born to a rich person already, and are faced with all of the risks of lottery winners who don't earn their money, and thus have no sense (see FMF's post's on the matter).
There is no excuse for the children of multi-millionares to ever need money from their parents, since the deck is stacked in their favor from birth, and by the time rich people die, their children should be in middle age, not a good time to be obsessed with windfalls from their parents. Further, knowing that their is no magic windfall coming is likely to encourage the children of rich people to work harder since they can't rest on their parent's laurels, and removes the danger of their wasting the money because they never had to learn its value.

Finally, who wants family fortunes passed down from generation to generation? Oligarchies and dynasties are inefficient and evil. There should be churn among the upper crust. The estate tax helps encourage the American ideal of people actually getting what they deserve, and the Christian ideal of wealth not being completely concentrated in a society.

In short, the estate tax is GREAT!

One technical point:
Roth IRA's are protected from the estate tax. Another reason to invest in them. An estate of one to three million dollars at the time of death could easily be arranged to be entirely in Roth IRA's, and thus escape tax entirely.

Hmm...that was clearly a rant. I'm not sure how to turn it back into civil discourse, and I want to at least get these ideas out there for response, so I'll leave it as is.

[JimL]

STL Pastor,

I could not disagree more. Taxing someone just because they are rich or that the children are not deserving is not a good reason. Taxes are assessed to help support the common services. Unfortunately, the political debates of the day focus putting more tax burden on certain people/activities versus the real problem in that the government continues to overspend.

[StLPastor]

JimL-
I agree that taxes are assessed to help support the common services, but my understanding is that they are something of a drag on production and efficiency, and cause inconvenience for those who have to pay them.
Thus, my argument is that taxes ought to be tilted towards those places where
1) they cause least inefficiency (carbon tax, gas tax, congestion taxes, other untaxed negative externalities increase the efficiency of our economy)
2) towards people that are least inconvenienced by taxes (the wealthiest)
3) where they encourage good behavior-like convincing the children of rich people to work harder, because they can't assume a huge sum of money will fall out of the heavens for them at the age of 50.

In short, I think its perfectly fine to tax people because they are rich or receive a windfall-those are the most efficient and least painful taxes, and morally, the wealthy are the people who have gained the most financially because they are part of this great nation.

However, I agree that the tax base in our country should be broadened as well-
the middle class should loose the ridiculous mortgage interest deduction, and the health care deduction, as those are causing significant distortions in our economy.

I also agree that the government does overspend in general. While the argument that the government needs to be deficit spending right now to help stimulate the economy seems persuasive to me (imagine if all the government workers who had to be fired to cut the budget were unemployed right now as well), I totally agree that we need to pass this health care reform bill before congress so as to slow the growth of the health care industry in this country before it bankrupts us-I was really excited to hear that the Congressional Budget office thinks the health care bill will save us nearly a trillion dollars over the next 20 years. I also wish the government would end the wasteful wars in Iraq and Afghanistan. The military should be able to get by on about 50% of what we currently spend.
Those two things alone would put us back on a very sound financial footing.

I really like Brad DeLong's work on these questions-he's a moderate economics professor who's main concern is fiscal responsibility and the long term health of the economy. http://delong.typepad.com/sdj/

I enjoy the dialogue, thanks for responding.

[Apex]

@Pastor.

A few things:

1.

You are mis-informed about the Roth IRA. It is not exempt from estate taxes. An estate's heirs absolutely will pay estate taxes on a Roth IRA if the estate is worth more than the estate tax exemption, just like any other IRA or any other asset owned by the estate.

2.

You said: "Christian ideal of wealth not being completely concentrated in a society"

Do you have a scriptural reference for that ideal? Clearly the Christ follower is directed to help those less fortunate, but I am not aware of any scriptural concept of wealth not being concentrated? In fact when Mary poored expensive oil on Jesus feet and Judas deried her asking why it was not sold and the money given to the poor, Jesus said the poor will always be with you, I will not. So Jesus seemed to be saying wealth will always concentrate, and he didn't seem to make any statement for or against it.

3.

Some of your points about efficiency seem valid but I think you under-estimate the efforts people will go through to avoid taxes. All kinds of money is wasted on lawyers, accountants, insurance policies and agents etc to try to avoid estate taxes. While a Roth is not exempt from the estate tax, the payoff of an expensive whole life policy owned by someone outside the estate is (because it's not owned by the estate). So lots of actions are taken and money is wasted to basically pay leeches who such funds off the rich to allow the rich to avoid getting even more funds sucked off at death by the IRS. That's a lot of inefficient actions being taken by someone who shouldn't care since he can't take it with them. But people do care very much about what happens to their estate.

In addition if people knew there was no way out of it at all, some would simply stop trying to grow their business beyond a point where it was clear they would just lose it all anyway. That would not stimulate the economy as the businesses with good growing models tend to stimulate the economy the most and create the most jobs.

In addition, even if they did keep growing it and then upon death it was worth 20 million and the heirs had no way to pay the tax to keep the business going it would need to be sold off and often split up or shut down and that is an inefficient outcome for something that is growing the economy.

So I don't think its always as simple as they are dead so there is no cost.

[JimL]

Here is another way to look at it. We all know the government has overspent. We then enter into the class warfare/politicl debate of decided who should pay more taxes and how. What is really going on is saying that we want to take more money out of the pocket of our neighbors to continue the path of fueling a government that is out of control when spending.

As to the healthcare debate, don't even get me started on that one. It is the biggest disaster yet to come. I have spent my entire career in the healthcare business and we are headed for a trainwreck if either the Senate or House bills get passed. They are both built on unreasonable expectations.

[StLPastor]

Apex,
I'm sorry to have been misinformed about the Roth IRA. It didn't take much research to prove I was completely wrong, and I feel a little silly. I stand corrected, thanks.

On the Christian values-the year of Jubilee prescribed in the Old Testament was a time for slaves to be freed, debts to be forgiven, and land to be returned to its original owners every 30 years, for the purpose of leveling society. Jesus preached the Year of Jubilee in his first sermon in Nazareth. Also, while he admitted that the poor are a fact of life, he lambasted those who consumed the widow's houses, told the rich young man to give all he had to the poor, and critiqued those who charged interest. Acts tells of a church where all shared as necessary to care for one another. Samuel warns that kings will concentrate wealth dangerously. The prophets critiqued those who had wealth, but ignored the needs of widows and orphans. I'm content to agree that leveling society is not a core Christian value (like caring for one another and the poor, and loving God) but I think there is a long Christian witness towards a more just distribution.

Obviously, some people will go to great lengths to avoid the estate tax, and that creates inefficiencies, but people also pay the estate tax, which reduces inefficiencies from taxing elsewhere. The evidence of small businesses being disrupted by the estate tax is as pointed out earlier quite minimal.

Jim, the people in the healthcare industry in my congregation are excited about the bill, for both the increased insurance coverage of uninsured people, getting them out of emergency rooms, and the potential cost control measures. What unreasonable expectations are you worried about?

[JimL]

STL,

It is a long discussion and takes some study. The costs will be significantly higher and some expected cuts will not materialize. Just take a look at the financial mess in Medicare if you want an example. This is an issue that really takes some work, but when you investigate the numbers, I think you will change your mind.

It would be great to increase coverage, but if we bankrupt the system, it will all fall apart and we will be in a much worse position.

[Estate Lawyer]

Economists agree the estate tax creates huge inefficiencies. All else equal, it's better if people try to create wealth. Taxing wealth - even at death - is a strong disincentive to its creation.

Consider, for example, a 100% estate tax. The rational course for everyone subject to such a tax would be to wastefully spend down wealth in their later years until the last check they write (i.e., on their deathbed) bounces. As death approaches, they would have no reason to invest well, insure capital goods against destruction, or lay plans for expanding future production.

Where, on the other hand, people can pass on wealth to their children, they have an incentive to invest wisely, spend carefully, and generally create wealth. That creating and preserving wealth is good for the economy is - I hope - self-evident, say what you will about the evils of dynasties.

The estate tax can be argued on moral grounds, but where efficiency is concerned, there really can be no debate.

[Jim]

I think taxing dead rich people is a good thing.

They could keep the exemption tied to inflation and readjust the tax rates so its more progressive. 55% is an awfully high tax rate, it should start like 10% and then gradually step up just like income taxes.

One key reason that they should have an estate tax is for capital gains that people accumulate and never pay taxes on. If you buy a property or stock and hold it for decades then you'll never pay tax on its appreciation, if thats passed free of tax to heirs then theres no tax on that income. There should not be loopholes to avoid taxation like that.

Carlos made a good point about small business & farms not really being hurt but he estate tax. Thats a strawman argument. Theres no real threat to small business or family farms due to the estate tax.

[Carlos]

Jim said: "...readjust the tax rates so its more progressive..."

It's already progressive! Currently (2009) the estate tax rates start at 18% and go up to 45%.

In 2011, the rates will range from 18% to 55%.

You can find rates and tax computations in http://www.nationalaglawcenter.org/assets/crs/RL33718.pdf

Also remember that it's similar to a marginal rate. The estate doesn't pay 55% of the total estate, or even 55% of the adjusted total. As I pointed out in a previous comment, even though the marginal tax rate on a $3.5 million estate in 2011 would be 55%, the tax paid would only be $1.22 million, which is a rate of 35% on the total estate. While that's still a lot, it's nowhere near 55%.

[Jim]

Carlos,

From that report you linked to:

"A shortcut is available to calculate the tax on the estates of decedents dying in 2006 through 2009. The estate tax liability can be calculated simply by multiplying the amount of the taxable estate in excess of the applicable exclusion amount for the year of death times the maximum estate tax rate for the year. The applicable exclusion amount is $2 million for 2006-2008 and $3.5 million for 2009. The maximum tax rate is 46% for 2006 and 45% for 2007-2009."

Basically the way it is setup right now the tax is effectively a flat tax of 45% on everything above $3.5M

So its not really progressive right now the way they've got it setup.

They have lots of brackets at 18-45% range but those apply to estates of value below the current $3.5M exclusion. But those brackets are moot since estates below $3.5M are exempted.

[Carlos]

Jim,

Good point. However, I would still argue that the tax is progressive. What is the definition of progressive? Princeton's wordnet (http://wordnetweb.princeton.edu/perl/webwn?s=progressive%20tax) defines it as "any tax in which the rate increases as the amount subject to taxation increases."

And technically that's true. For 2009, the rate is 0% for estates between $0 and $3,500,000. Then the rate is 45%. So clearly the rate increased as the amount subject to taxation increased. If the tax was 45% on ALL estates regardless of size, then it would not be progressive.

Also, according to the same report, the shortcut only applies to 2007-2009. My example calcs were for 2011, the same as the original FMF post. If the tax laws do not change (which is unlikely), then the tax is clearly progressive for 2011.

[Wayne Jordan]

The small businesses in danger of being liquidated at death are sole proprietorships. Corporations and LLC's survive death. Most SP's don't have an exit plan. If they did, they could plan for the death of owner and avoid this entire issue.