The following is excerpted from a blog by Deborah L. Jacobs on the Personal Finance blog at Forbes, dated 1/2/2013, updated 1/11/2013.
[Congress passed and the President signed, a set of laws designed to avert the so-called “fiscal cliff” earlier this month. Among that legislation are a number of changes, some of which are now permanent, to the federal estate tax laws.]
Who has to pay federal estate tax?
Once you’re worth more than a certain amount, taxes shrink your estate. Under the 2010 tax law, we can each transfer up to $5 million tax-free during life or at death. That figure is called the basic exclusion amount, and it is adjusted for inflation. In 2012 it was raised to $5.12 million per person. The new tax law does not change how much you can pass tax-free. On Jan. 11 the IRS announced that, with the inflation adjustment, the estate tax exclusion amount for deaths in 2013 would be $5.25 million.
Do spouses have to pay the tax when they inherit from each other?
The new law doesn’t change this either. There is an unlimited deduction from
estate and gift tax that postpones the tax on assets inherited from each other
until the second spouse dies. This marital deduction, as it is called, applies
only if the inheriting spouse is a U.S. citizen.
How much can the second spouse pass tax-free?
Here’s where things get a bit complicated — but in a good way. The 2010 tax law gave married couples a wonderful tax break, which the new law has made permanent. Widows and widowers can add any unused exclusion of the spouse who died most recently to their own. This enables them together to transfer up to $10.24 million tax-free. Tax geeks call this portability.
Still, portability is not automatic. The executor handling the estate of the spouse who died will need to transfer the unused exclusion to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate. The prerequisite is filing an estate tax return when the first spouse dies, even if no tax is owed. Let’s hope that the Internal Revenue Service develops a short form for the purpose. This return is due nine months after death with a six-month extension allowed. If the executor doesn’t file the return or misses the deadline, the spouse loses the right to portability. Spouses should file it even if they’re not wealthy today, because who knows what the future holds?
How does this relate to lifetime gifts?
The lifetime gift tax exclusion and the estate tax exclusion are expressed as a total amount – currently $5.25 million per person – and it is possible to use this exclusion (sometimes called the “unified credit”) to transfer assets at either stage or a combination of the two. If you exceed the limit, you (or your heirs) will owe tax of up to 40%. The IRS expects you to keep a running tally and report these gifts so it will know how much has already been used up when you die. For example, if you have used $1 million of the exclusion to make taxable lifetime gifts, the unused exclusion if you die in 2013 will be $4.25 million, rather than $5.25 million.
Here too, couples get a special break: they can share the basic exclusion during life (this process is called gift-splitting) and give more to the kids now, tax-free. But of course this also reduces how much of the tax-free amount will be available when they die, either for their own use or to be carried over by the survivor.
Are there lifetime gifts that don’t count?
Absolutely, and this is a common source of confusion. We can each give another person $14,000 per year without it counting against the lifetime exemption. (The amount went up at the end of 2012, as I reported here.) Spouses can combine this annual exclusion to double the size of the gift. Don’t confuse it with the basic exclusion–that $5.25 million discussed above.
For example this year, relying on the annual exclusion, a married couple with a child who is married and has two children could make a joint cash gift of $28,000 to the adult child, the child’s spouse and each grandchild – four people – providing the family with $112,000 a year. Only gifts that exceed the limit count against the lifetime exclusion. The simplest way to use the annual exclusion is to give cash or other assets each year to each of as many individuals as you want. Another possibility is to put money in Section 529 education savings plans. Establishing these plans for relatives could relieve siblings or children of the need to save for college at a time when they are overwhelmed with current expenses.
Should you redo your will?
Nearly 2.5 million Americans die each year, and many haven’t signed the basic documents needed to protect loved ones. But let’s say you took this important step within the past five years. The latest tax law probably doesn’t give you any reason to alter your plan. But you
should revisit it if there have been changes in your finances or your personal life.