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Investing Specialists

What Changes in the Estate Tax Mean for You

Don't let 2010's estate-tax oddities affect your plan.

Even in normal times, estate planning is a complicated topic. And these are not normal times.

When the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 eliminated the federal estate tax for 2010, there were jokes that this would be a good year for wealthy folks to die.

Now that we're here, however, the repeal of the estate tax doesn't appear to be all that it was cracked up to be. For one thing, it's far from certain that the estate tax will, in fact, be repealed for 2010. Many tax pundits think Congress will take action to reinstate it within the next few months, and if that happens, the new estate tax policy could be retroactive to Jan. 1 of this year. Moreover, even if estate-tax repeal stands for 2010, that doesn't mean everyone gets off scot-free. The current rules regarding cost basis have the potential to create huge headaches for the loved ones of individuals who die with assets above a certain level.

Here are some of the key details of where things stand right now and how to think about estate planning given all of the uncertainty.

What's Happening in 2010
In a nutshell, the estate tax is a tax on the value of the property of a deceased person. If those assets don't add up to a certain level, the estate isn't subject to tax. But if the decedent's assets exceed a certain threshold--and that amount varies by year--the estate is subject to tax.

The estate tax was gradually phased out from 2002 through last year; in 2009, estates of more than $3.5 million were not subject to estate tax. And in 2010, the estate tax is eliminated altogether, even for multi-million-dollar estates.

There are a couple of huge wrinkles, however. One, as I noted earlier, is that the estate tax could be reinstated for 2010, giving the IRS the ability to "claw back" estate taxes that weren't paid because of estate-tax repeal but that are due under whatever new estate-tax system Congress puts in place.

The second big headache for families whose loved ones pass away in 2010 are the rules regarding the cost basis of inherited property. If you inherited assets prior to this year, you know that you were able to receive a "step-up" in cost basis. Say, for example, you inherited some  Hewlett Packard (HPQ) stock from your grandfather, who paid $10 each for the shares. If your grandfather passed away in June 2009, your cost basis would be the stock's price when he died--about $37. So if you eventually sold the stock for $55, you'd owe capital-gains tax on the $18 in appreciation since you inherited it, not the $45 spread between your grandfather's purchase price and your own sale price.

But that attractive step-up goes away in certain situations under the current estate-tax law. Spouses can receive a step-up in basis on $3 million in inherited assets, and nonspouse beneficiaries can receive the step-up on inherited assets worth less than $1.3 million. Those inheriting assets above those levels, however, will receive the decedent's own cost basis in the assets. That creates a headache not just because you could owe more taxes when you sell, but also from a record-keeping standpoint, as you'd have to sleuth around to find out exactly what your grandfather paid for his shares.

2011 and Beyond
Unfortunately, the estate-tax horizon isn't any less murky once you get beyond 2010. The estate tax is set to revert to its pre-EGTRRA levels in 2011, meaning that a 55% estate tax would be due on estates greater than $1 million. Tax-code watchers have argued that Congress would be unlikely to leave such an onerous system in place. But as this year's convoluted system attests, anything is possible.

What to Do?
Given all the uncertainty and the fact that many attorneys aren't even sure what to advise their clients, it's not surprising that many individuals are in a state of estate-planning paralysis. So what should you do?

While it's true that you'd probably want to avoid a major rewrite of your estate plan at this juncture, it's important to recognize that estate planning is a lot more than just tax avoidance. Estate planning also involves drafting documents to ensure that your wishes are carried out if you die or become disabled--such as a living will. It also entails choosing individuals to act on your behalf--an executor, durable (financial) power of attorney, power of attorney for health care, and guardian if you have minor children. Drafting those documents and selecting those key individuals is important no matter what, but especially if you've recently had a major life change--for example, you've recently gotten married or had a child. Updating beneficiary designations is another important, and mostly evergreen, aspect of estate planning; estate-planning attorney Susan Jones provides some specific guidance in this article.

And while many tax pundits argue that the current rules regarding the cost basis of inherited assets will be eliminated once Congress revisits the estate tax, the current kerfuffle illustrates the importance of keeping good records on cost basis--the price you paid for individual securities in your taxable portfolio, including commissions and other expenses. Precise record-keeping of cost basis can not only aid in the estate-planning process, but also enables you to take advantage of more sophisticated tax-loss selling methods, such as specific share identification. Brokerage and mutual fund firms, as well as financial software packages, have begun providing increasingly sophisticated tools for tracking your cost basis. But setting up your own tracking system isn't difficult. Simply get in the habit of recording the name and number of shares you purchased, as well as the dollar amount and the date on which you purchased them. (Don't forget reinvested dividends.) 

See More in Our Tax Relief Center

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