Will You Owe Estate Taxes?

Updated on January 23, 2009.

THE GOOD NEWS is it's becoming increasingly less likely that you'll owe federal estate taxes. That's because the amount an individual can leave to heirs free of federal estate taxes in 2009 is $3.5 million (up from $2 million in 2006-2008).

Still, with retirement accounts, homes and life insurance death benefits thrown into the pot, it's easier than some think for a working couple to be subject to the federal estate tax. And this tax can be brutal. For every dollar more than $3.5 million that you leave behind, Uncle Sam will take 45 cents.

Want to know where you stand? Well, plug your assets and liabilities into our Estate Tax Exposure Meter. If it looks like your heirs will be sharing their bequests with Uncle Sam, don't fret. There are plenty of things you can do right now to make sure that the prime beneficiary of your life's hard work isn't the government. In fact, the Meter will make some suggestions that apply to your situation.

Your next step is to read our story You've Gotta Start Somewhere. There you'll learn about bypass and QTIP trusts which can help you and your spouse double the amount you can leave to heirs tax-free. Then, you'll need to brush up on our other estate planning subjects like Gift Taxes and Roth IRAs.

One more thing. Even though the current law calls for complete repeal of the federal estate tax in 2010, believe it when you see it. Estate tax planning remains critically important until the repeal actually occurs — if it ever does. More likely, the current $3.5 million exemption will be made permanent. 

Taking advantage of the $3.5 million exemption amount and the relatively simple planning strategies explained in this section will prevent any federal estate tax hit in the vast majority of cases. But first, use this calculator to assess how much you would owe right now in the absence of any estate tax reduction moves.

Note 1: You can avoid estate tax on life insurance proceeds by setting up an irrevocable life insurance trust to own the policies on your life. However, if you transfer an existing policy into a life insurance trust, it is still considered part of your estate until three years have passed. For more details, see Check Your Life Insurance.

Note 2: Please enter the amount of net worth included above that would end up in your spouse's hands. Include both his or her separately owned share of the net worth plus the share that would be inherited from you.

Example 2: You have $3 billion in assets (or $3 million, whatever). You can transfer all or part of that wealth to your spouse — assuming he or she is a U.S. citizen — by gift or via bequest. No federal gift or estate taxes are due, and your federal gift and estate tax exemptions remain intact. So even after any transfers to your spouse, you can still move up to $1 million to other persons (typically your children or grandchildren) by gift or up to $3.5 million by bequest. No federal gift or estate taxes will be due there either.

Note 3: While you are alive, you can gift up to $13,000 to an individual recipient each year without owing any federal gift tax or using up any of your $1 million gift tax exemption or any of your separate estate tax exemption. (For 2006-2008, this figure was $12,000; for 2002-2005, it was $11,000; and prior to 2002, it was $10,000.) If you are married, the current annual tax-free gift limit is $26,000 per recipient if you and your spouse make joint gifts. While still alive, you can also give away an unlimited amount as long as the money goes directly to an educational institution for tuition or to a medical service provider to pay for uninsured expenses.

Note 4:

Planning Suggestion 2: Another likely explanation for a tax bill on your spouse's estate is "unbalanced estates." Say your estate is well under the $3.5 million exemption and your spouse's estate is well over the magic number. If you die first, your estate won't owe any tax, but it isn't big enough to take full advantage of your $3.5 million exemption (even with a bypass trust arrangement). When your spouse dies, his or her $3.5 million exemption won't be enough to fully shelter against the federal estate tax.

If this is the case, consider transferring assets between you and your spouse to more or less balance your estates. That way, you can each shelter up to $3.5 million with a bypass trust arrangement. Another possible solution to the "unbalanced estates" dilemma is a QTIP trust arrangement. See You've Gotta Start Somewhere for further explanation.

Planning Suggestion 3: Yet another possible cause of a tax bill on your spouse's estate is when he or she winds up with more cash than is really needed from life insurance death benefits after you die.

If this is the case, consider setting up an irrevocable life insurance trust with your kids as the beneficiaries. The trust then takes over ownership of the "excess" life insurance coverage. That keeps the death benefits out of both your taxable estate and your spouse's taxable estate. When you die, the death benefits are paid to the trust. The trust fund can then be used to finance your children's college educations. Or you can arrange for staggered trust fund payouts when your children reach certain ages (say 30, 40 and 45). Or both. See Check Your Life Insurance for further explanation.

Planning Suggestion 4: The fourth-most-likely reason for a tax bill on your spouse's estate is that you and your spouse are just plain wealthy. In this case, you should consider more aggressive tactics. Consider making gifts to your children, grandchildren, other loved ones and charities to reduce the value of both your taxable estate and your spouse's taxable estate. For the specifics, see Start Giving It Away Early; Estate Planning with a Roth IRA; and Charitable Trusts.

Note 5: While you are alive, you can gift up to $13,000 to an individual recipient each year without owing any federal gift tax or using up any of your $1 million gift tax exemption or any of your separate estate tax exemption. If you are married, the current annual tax-free gift limit is $26,000 per recipient if you and your spouse make joint gifts. While still alive, you can also give away an unlimited amount as long as the money goes directly to an educational institution for tuition or to a medical-service provider to pay for uninsured expenses.

Example 1: You pay $25,000 directly to a private college to cover your grandchild's tuition (not room and board, books, or supplies). This gift doesn't use up any of your $1 million exemption, nor does it preclude you from making an additional tax-free gift under the $13,000 rule. So you could transfer another $13,000 by writing a check to your grandchild for room and board, books, supplies, personal expenses, and whatever. If you have two grandchildren, you could do the same for both. Your $1 million gift tax exemption and separate estate tax exemption both remain fully intact.

Example 2: Say you are single. In 2004, you gave $25,000 to your adult daughter to help her start a business. This means you made a taxable gift of $14,000 ($25,000 minus the $11,000 "freebie" that applied for 2002-2005; gifts made prior to 2002 were subject to a $10,000 limit). If you never made any other taxable gifts, you would enter $14,000 on the taxable gifts line. If you are married and you and your spouse jointly made the $25,000 gift, the taxable gift is only $3,000 ($25,000 minus your $11,000 "freebie" minus your spouse's $11,000 "freebie"). You should enter $1,500 on the line for your taxable gifts and $1,500 on the line for your spouses taxable gifts.

Note 6:

Planning Suggestion 2: If you are single, the most likely cause of a big tax bill on your estate is lots of life insurance coverage. If this is the case, consider setting up an irrevocable life insurance trust with your kids — or whomever you wish — as the trust beneficiaries. The trust then takes over ownership of the insurance policies on your life. That keeps the death benefits out of your taxable estate (and out of your spouse's taxable estate if you are married). When you die, the death benefits are paid into the trust. The trust fund can then be used for whatever purposes you specify in the trust document (for example to pay for your child's college education or to make staggered payouts when the beneficiary reaches specified ages). See Check Your Life Insurance for more on irrevocable life insurance trusts.

Planning Suggestion 3: The other likely reason for a tax bill on your estate is that you are wealthy, plain and simple. In this case, you should consider more aggressive tactics than the ones explained above. Consider making gifts to your children, grandchildren, other loved ones, and charities to reduce the value of your taxable estate. For the specifics, see Start Giving It Away Early; Estate Planning with a Roth IRA; and Charitable Trusts.