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No Head in the Sand on Your Estate Plan

Christine Benz

Christine Benz: Hi, I'm Christine Benz fpr Morningstar.com.

The closing days of 2010 brought a flurry of changes on the estate tax front. Here to discuss them and what they might mean for you is Tom Abendroth. He is an attorney at Schiff Hardin and estate planning specialist.

Tom, thanks so much for coming in.

Tom Abendroth: You are very welcome.

Benz: So, let's discuss some of the big headlines associated with the changes in the estate tax laws. Now, there is a $5 million exemption from the estate tax. So, I think a lot of people might be thinking, "Well, with numbers that large, maybe this is a whole area that I don't need to worry about." What's your take on that question?

Abendroth: It is a natural reaction, Christine. First of all, everyone has to remember that these current provisions, the $5 million exemption amount, 35% tax rate, are only guaranteed for the next two years.

Benz: So, through the end of 2012.

Abendroth: That's right. At the end of 2012, all of this expires unless Congress does something first. Everyone expects them to do that and to extend the law, but of course there are no guarantees. So, from a tax standpoint, skipping all the planning only works if you know you're going to die within the next two years.

From a non-tax standpoint, of course, all the other things that you need to worry about in estate planning still exist: Do you have minor children; do you have a child with special needs; do you have adult children who are not ready for an inheritance yet, so maybe there should be a trust for them? And for a spouse, do you want property outright where the spouse can dispose of it to anybody, including a new spouse? Or do you want that in trust? All those decisions, of course, still are ones you need to deal with.

Benz: And they're kind of evergreen decisions.

I think, a natural question is, we've seen these pretty substantial changes in the estate tax rules over the past few years, and people may be wondering, "Well, how do I create a plan that stands the test of time? That can actually be flexible and allow my plan to be a decent plan regardless of how we see these laws moving?" What's your take on how to do that and what provisions to put into a plan so it is flexible?

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Abendroth: Well, believe it or not, we estate planning attorneys have thought about that for a long time, and in fact, have always tried to build in a lot of flexibility in estate plans. So for example, the ones that were done maybe even before 2000 worked fine through that decade, they worked okay in 2009, functioned okay in 2010, and still function today--maybe not perfectly, like an old car, they have problems, but they get the basic things done.

There is one change now that we are really seeing a lot of, and that is not to depend anymore on formula allocations of assets that are purely tax-based.

Benz: So, explain that in layperson's terms.

Abendroth: Sure, so a lot of people are familiar with a credit shelter trust or a bypass trust designed to use the exclusion amount for estate tax purposes.

Benz: So each spouse would have one of these trusts and send assets into it with the idea of fully using up ...

Abendroth: ... Their exclusion. So at the first death, whoever dies first, the assets go into that trust equal to the amount of the exclusion, and they are protected from estate tax, and then other assets would pass to the spouse.

So it typically was purely formula based, based on whatever the exclusion is. Well, think about it over the past five, six years, and what it might be a couple years from now. Is it a $5 million exclusion? Is it a $3.5 million exclusion? Is it a $1 million exclusion? Well, that's a big difference in numbers. So what we've been counseling clients to do is consider figuring out their allocation just based on how they want the property allocated. 70% to spouse, 30% to a trust for the kids and spouse, but maybe limited then by the amount of the exclusion. And that way you're not completely controlled by whatever the tax law says. It creates again a little more flexibility.

Benz: So, a question is related to the credit shelter or bypass trusts that a lot of households have. Are they defunct now, so say they did have one of these formula setups?

Abendroth: Allocations?

Benz: Yes.

Abendroth: Sure. Again, for the next two years absolutely not because while the exclusion is very high and we have this concept of possibly being able to use the other spouse's exclusion, these changes are only guaranteed for the next two years. So, it may be that the credit shelter trust is a very important tool even for someone with only $2-$3 million, if the exclusion reverts back to $1 million exclusion.

Benz: Okay. So, you don't need to go back and undo the trust that you've had set up?

Abendroth: That's correct. Now, if this all becomes permanent, I think a lot of people are going to rethink the way they do their estate plans, and at least explore the possibility of simplifying it in a variety of ways. But on the other hand, if you have an opportunity at the first death of husband and wife to set aside property in a tax-sheltered form, even if you don't think you need it, I think a lot of people will decide that that's what they want to do just in case 10, 15, 20 years from now Congress decides we need a lot more money and let's go back to an old more rigorous estate tax law.

Benz: So, you alluded to it, Tom, this concept of portability, of spouses being able to sort of share exemptions. Can you talk about how that works?

Abendroth: Certainly. This is an idea that's been around for a while, and it's actually quite nice that Congress finally adopted it. Again, unfortunately, it's only around for the next two years guaranteed, but here is the concept: Your spouse predeceases you, leaves $2 million into a credit shelter trust, and that's all they've got. So, now they filed or their executor files an estate tax return, and that's important they have to do that to get this portability, and they elect to allow their remaining exclusion of $3 million--so, the rest of the $5 million--to transfer that to the surviving spouse. So, the surviving spouse now has $8 million of exclusion, could shelter up to $8 million of property at his or her death.

Now, assume the surviving spouse remarries, and remarries a very wealthy gentleman worth maybe $10 million--I guess that's a good thing--and unfortunately that second spouse also dies before the wife.

So, she is left now with a second husband who has predeceased her. He leaves $5 million of his property to his kids uses up all his exclusion. At that point, she is back to a $5 million exclusion. It's the exclusion available from the last spouse to die. So, this has sort of been viewed as an anti-black widow provision, someone going out and trying to accumulate exclusion by marrying older gentleman or older woman. It doesn't work.

Of course the other thing that people have to keep in mind for right now is you only get this portability if both husband and wife die before the end of 2012. Unless they extend it, it doesn't last beyond that. So, certainly don't count on it being there right now.

Benz: But for now it's kind of a nice flexible provision.

I want to touch briefly on some of the key estate planning pitfalls that you've seen in your practice and also some ideas for how people can avoid them?

Abendroth: Sure. I'm going to look at two ends of the spectrum here. One end of the spectrum: Doing nothing. It's so common people; put their head in the sand. They want to think about it. And it's a process that really isn't that painful, and you don't have to do it every year, but if people will actually confront the changes they need to make, update their estate plan, they can save their families hundreds of thousands of dollars.

Benz: And hours probably, too, hours of time.

Abendroth: And time and disruption and all of that. The other end of the spectrum is what I call sort of the packaged estate plan. The people who are out there who will say, we have this package of techniques, and if you do this, we will eliminate all your estate taxes.

Well, it's never an all-or-nothing game. You should be suspicious about that with good reason. It sounds too good to be true, and it probably is. Estate planning is a process, and it takes place over a many year time period, and it rarely accomplishes the goal for at least a very wealthy individual of eliminating a 100% of the tax.

Benz: And I'm sure there are very individual situations that could call for a more customized plan than perhaps someone is saying they'll give you.

Abendroth: Absolutely. It's not a matter of selling a package or a product. It is very a customize thing.

Benz: Okay, well thanks Tom for sharing your insights. We really appreciate you being here.

Abendroth: You're welcome.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.