But..

Thus, in all other areas of your life, you avoid taxes simply by doing nothing. But doing nothing when it comes to estate planning is exactly how you will pay taxes. Indeed, estate taxes are optional: You pay them only if you fail to take the proper steps to avoid the tax. This chapter is designed to show you the proper steps.

The Magic Number

When a person dies (the decedent), his estate is distributed to his heirs.

Before heirs receive anything, the IRS has first dibs. The estate tax is assessed against the estate’s net worth, which is simply what the decedent owned (the assets) minus what the decedent owes (the liabilities).

And in case you’re keeping score, only 3% of the U.S. population has a net worth in excess of a half million dollars.

If your net worth is less than $2,000,000, your estate is not subject to estate taxes. But every dollar above that figure will be subject to tax.

Two Mistakes in Your Arithmetic

If you think you’re not worth $2,000,000, don’t make the mistake of thinking you have nothing to worry about, for two reasons.

Math Mistake #1: You Did Not List All Your Assets

In addition to your ordinary assets, such as your home, cars, bank accounts, investments, IRAs and personal possessions, you also need to include:

Math Mistake #2: You Think You Are Worth Less Than $2,000,000

Keep one point in mind: You’re not dead! (I know, because if you were, you wouldn’t be reading this book.) By the time you are dead, you almost certainly will be worth $2,000,000 — and more!

Let’s look at Beth, age 45, whose net worth is $200,000. Assuming her assets double every 10 years (which would happen with a 7% annual growth rate), Beth will be worth $400,000 at age 55 and $800,000 by 65. And she’s still not dead! By 75, she’ll be worth $1.6 million and $3.2 million by age 85. Her tax liability by then would be about $500,000. Now that’s a problem!

How to Reduce Your Estate Tax

To solve this problem, you need solid planning. Let’s see the difference we can make. Each of the following examples are based on Mike and Sue, who have a net worth of $6 million. For simplicity, we’ll assume their assets are split equally between them, although in real life it’s rarely that simple. We’ll also assume Mike dies first and that Sue dies shortly afterward, before the estate increases in value.

Simple Wills

Our first example, shown in Figure 9-2, assumes that Mike and Sue leave everything to each other, then to their kids after the surviving spouse dies. This is called a simple will.

Mike dies, leaving everything to his wife Sue. When she dies, she leaves everything to their children.

We showed earlier the administrative problems posed by simple wills. Here we see that simple wills create huge tax liabilities as well. But interestingly, the tax problems occur not at Mike’s death, but at Sue’s. This is because you are permitted to leave an unlimited amount of money to your spouse without incurring any estate tax. Thus, Mike can leave his entire $3 million to Sue (making her worth $6 million) and no tax is due. This often lulls people into falsely believing that they need not worry about estate taxes.

The kids expect to inherit Sue’s assets tax-free when she dies. After all, there was no tax when Dad died, so it follows that there will be no tax when Mom dies, too. Right?

Wrong. When Sue dies leaving $6 million to the kids, only(!) the first $2,000,000 passes tax-free. The rest — $4,000,000 — is subject to taxes at a rate of 46%. Sue’s estate thus will pay $1,840,000 in taxes, and her children will inherit only $4,160,000 million, instead of the $6 million Sue expected.

It doesn’t have to be this way. Through proper planning, we can dramatically cut that tax bill, safely and securely, simply by following the rules provided by Congress.

Estate Taxes Are Optional

Congress made estate taxes optional: You pay only if you fail to take the steps needed to avoid the tax.

The first step, is to use a Bypass Trust (so named because it allows a portion of your estate to “bypass” the tax; It’s also known as an A/B trust, a unified credit trust and a credit shelter trust). Mike leaves Sue only $1,000,000, placing the remaining $2,000,000 in the Bypass Trust.

Since Sue receives only $1,000,000, her estate is worth $4,000,000 (her 2 million plus Mike’s $1,000,000). Therefore, the estate tax at her death is only $920,000, a savings of $920,000.

But, Sue wonders, what about the $2,000,000 that Mike placed into the Bypass Trust?
It goes to the kids tax-free.

That’s great, but what about me? Have I lost $2,000,000?

Not at all. Think of a trust as a bucket. As the donor, Mike:

When Mike creates his Bypass Trust, he names his wife Sue as both trustee and primary beneficiary; the kids are secondary beneficiaries. Mike further states that Sue, as beneficiary, is entitled to receive both income and principal from the trust throughout her lifetime, provided that the trustee agrees that the distribution is needed for her maintenance, education, support, and health (known in estate planning circles by the acronym MESH). Any assets remaining in the trust at Sue’s death then pass to the children, who are the secondary beneficiaries.

Thus, has Sue lost the $2,000,000 that Mike gave to the trust? Not at all. To get the money, she simply needs permission from the trustee — who is herself!

But since Mike placed the $2,000,000 into the trust, it is excluded from the estate tax calculation, which in turn saves $780,000 in estate taxes.

The kids, therefore, inherit $5,080,000 — $3,080,000 from Sue and $2,000,000 from Mike’s Bypass Trust.

Bypass Trusts Are Limited to $2,000,000

If the Bypass Trust is such a great deal, why is Mike placing only $2,000,000 there? Why not his entire $3 million?

Because it won’t do him any good. Remember that Congress allows you to leave an unlimited amount to your spouse, but only $2,000,000 to a non-spouse. Therefore, if Mike had left more than $2,000,000 to the trust, everything above that amount would have been taxed, defeating the purpose. This reveals the secret to the Bypass Trust: It preserves Mike’s ability to pass $2,000,000 to his kids tax-free, an ability he would have lost if he had first left everything to his wife. Since Sue also is able to pass $2,000,000 tax-free to the kids at her death, Bypass Trusts allow married couples to shelter up to $4,000,000 from estate taxes.

Bypass Trusts are not needed when the estate is less than $2,000,000, since there is no tax on estates valued up to that amount. But for married couples whose estates are between $2,000,000 and $4,000,000, the Bypass Trust will completely avoid all estate taxes.

The $2 Million Figure Increases Every Year, but...

The amount of money you can leave to heirs without incurring the estate tax is $2 million for 2006-2008, and this figure rises to $3.5 million by 2009. In 2010, it gets even better: In that year, you can leave heirs an unlimited amount of money. That’s right: the estate tax disappears completely in 2010.

But the tax comes back in 2011! And it returns with a vengeance: Starting in 2011, you'll be able to leave heirs only $1 million tax-free.

...The Bypass Trust Works Only for Married Couples...

It’s an example of how the tax code discriminates against those who are not
married — and why, if you are married, you must establish these trusts while you both are alive. When one spouse dies, it’s too late.

...And Only for U.S. Citizens...

Bypass Trusts work only when both spouses are U.S. citizens. If you are worth more than $2,000,000 and married to a non-citizen, you need to see an estate attorney to learn about a Qualified Domestic Trust. This trust was designed to reduce the estate taxes for Americans who marry non-citizens.

Insurance Trusts

Although the Bypass Trust protects $6 million of Mike and Sue’s money, we still have work to do, for they still would lose $920,000 to estate taxes. The solution uses an Irrevocable Life Insurance Trust in addition to a Bypass Trust.

While both are alive, Mike and Sue establish and give money to an Irrevocable Life Insurance Trust. They name the children as both trustees and beneficiaries. The trustees (read: children) use the money in the trust to buy a special type of life insurance policy, called a “survivorship life” policy.

This type of policy, also called second-to-die, (a) insures the lives of both Mike and Sue, (b) is owned by the trust, and (c) names the trust as beneficiary.

Although Mike and Sue are both insured, this policy does not pay a claim at the first death. There’s no need because there’s no tax liability at that time. Rather, the death benefit is paid at the second death (hence, the policy’s name), and it insures both Mike and Sue because we don’t know who will die first. (We could buy two policies instead — one on Mike and one on Sue - but that’s more expensive. Besides, we don’t need coverage on both of them — just on the one who dies second. This is why the insurance industry created this type of policy.)

At the second death, the insurance policy pays the death benefit to the trust, which in turn distributes the money to the children.

How much money? If you set it up correctly, the amount of insurance paid to the trust will equal the amount owed in estate taxes. Thus, instead of estate taxes being paid out of the estate, the taxes are paid by the proceeds of the insurance policy. Sure, Mike and Sue pay the policy’s premium, but that’s a tiny amount compared to the actual estate tax itself. In fact, you can pay 90% of your estate taxes or more
this way.

Second-to-die life insurance also makes it possible to obtain insurance even if one spouse is uninsurable. Since the carrier doesn’t pay until the second death, it is largely unconcerned about a spouse who might be in poor health, provided the other spouse’s health is better.

Not Just a Clever Way to Sell Insurance

This strategy is not simply a back-handed way to get you to buy life insurance. The alternative is to pay the taxes out of your assets, which would be far more expensive.

Besides, if you already own insurance, you might not need to buy a new policy. You may be able to transfer existing policies to the insurance trust. This provides two benefits: It removes the insurance from your estate (which lowers your estate tax liability) while providing the money that the kids need to pay the tax.

I once met with a new client whose net worth was $10 million. His estate tax would have been roughly $5 million, or half his estate. To avoid that problem, he bought a $5 million insurance policy. When I asked him if he had established a life insurance trust, he replied that, no, he had bought the policy in his own name. His insurance agent never mentioned anything about a trust. But by owning the policy himself, the death benefit was now part of his estate. Thus, he no longer was worth $10 million, but rather $15 million — and the estate tax was now $6.8 million instead of $5 million! His agent didn’t solve the problem — he made it worse!

This is why you need an insurance trust: If Mike and Sue tried to solve their estate tax problem by buying insurance on their own, instead of through a trust, they would have increased the estate tax instead of reducing it!

Thus, if you are 65 or older and are worth more than $2,000,000, you should not own your own life insurance policies, for the death benefits would merely increase the size of your estate, which increases the tax your estate will owe.

A Warning When Transferring Policies to an ILIT

When you transfer a policy you own to an insurance trust, make sure you don’t die for three years. If you do, the IRS will deem that you made the transfer “in contemplation of death,” and your estate will be required to pay taxes on the value of the death benefit as though the transfer had never occurred.