Tax implications should be part of plan

Estate taxes are harsh, complicated – and affect very few Americans.

Federal law exempts from tax estates that are below a certain value. That threshold is $1.5 million this year and next.

In addition, the law allows spouses to bequeath an unlimited amount to one another free of tax.

But while most people don’t have to fret about estate taxes, they are a peril for many of those who live in expensive areas of the country. In Washington, D.C., for example, a house in a nice neighborhood plus some life insurance can easily propel a family into potential tax problems.

An elementary and widely recommended estate-planning strategy is to make sure both spouses take full advantage of the individual exemption. Leaving everything to the widow, for example, results in no tax at the husband’s death, but it also vaporizes his exemption (which is technically a tax credit), so that at the widow’s death she has only her single exemption to apply to the estate total.

The math is simple: Under current law, a couple that preserves both exemptions can pass $3 million to their heirs tax-free; if they allow one of the exemptions to go unused, the tax-free total is only $1.5 million.

A standard technique is to arrange for the first person to die to leave an amount equal to his exemption to a trust and the rest to the widow. This can be done via revocable trusts set up before death or testamentary trusts set up under the will – but should be done with the advice of an experienced estate-planning attorney.

Congress has made the matter more difficult by constantly changing the rules.

While the exemption is $1.5 million for 2004 and 2005, it goes to $2 million in 2006 and to $3.5 million in 2009. The estate tax is then scheduled to vanish altogether in 2010, but unless Congress acts it will pop back into existence in 2011 and the exemption will drop back to $1 million.

Given this environment, estate plans should be very flexible, and updated often.