Stayin' Alive: How to Cheat The Estate Tax

You still can't take it with you. But by timing your death, you can leave more of it to your heirs.

As ghoulish as it sounds, thousands of high-net-worth Americans who care about the financial well-being of their heirs have a powerful tax incentive to survive until at least Jan. 1, 2009. On that day, the federal estate-tax exclusion is scheduled to jump to $3.5 million from $2 million this year.

"No respirator plugs will be pulled in December," predicts Michael Graetz, a Yale Law School professor and co-author of a 2005 book on the estate tax, "Death by a Thousand Cuts."

The top estate-tax rate, now 45%, won't change. But raising the exclusion by $1.5 million could translate into tax savings of hundreds of thousands of dollars for heirs fortunate enough to have a wealthy benefactor who continues breathing until New Year's Day.

Some affluent Americans already are keenly aware of the increased importance of staying healthy. "It's less important to have a lawyer for sophisticated estate planning than to have a good cardiologist," says Douglas E. Schoen, a New York political consultant and author who expects to leave a large estate.

The imperative to stay alive is likely to take on growing importance in the final weeks of 2008, especially for wealthy people in poor health. But based on current law, there's an even bigger incentive to survive until 2010. In that year, the federal estate tax is scheduled to disappear entirely, only to reappear again in 2011 with a $1 million exclusion for 2011.

Don't bet on total repeal of the estate tax, though, even for one year. Financial planners, accountants and lawyers expect Congress and the next president -- whether it be Sen. Barack Obama (D., Ill.) or Sen. John McCain (R., Ariz.) -- to reach a compromise that will retain the estate tax in some form.

"The one thing we all know cannot happen is what current law says will happen," says Mr. Graetz, referring to the current law killing the estate tax in 2010 and reviving it in 2011 with only a $1 million exclusion. "That means Congress must act next year, no matter who's president."

So what will Congress do? Although nobody knows, it's significant that, under both candidates' plans, only a tiny fraction of all estates would get hit by the federal estate tax. "Our calculations from IRS and other data sources indicate that Obama would tax less than one-half of one percent of all estates of people dying in the U.S. -- and McCain would tax less than one-quarter" of one percent, says Clint Stretch, managing principal of tax policy at Deloitte Tax LLP in Washington.

So what should well-to-do families do until the dust settles? For a look at what could lie ahead, we've provided, below, the proposals of Sens. Obama and McCain, based on interviews with their advisers, and calculations done by Deloitte for The Wall Street Journal on how families would be affected by them -- as well as advice from tax planners.

The Obama Plan. Sen. Obama proposes a $3.5 million exclusion in 2009 and thereafter, with a top rate at 45%. His plan will "fully repeal the estate tax for 99.7% of households," says Jason Furman, Sen. Obama's economic policy director.

"He would add certainty and stability to the tax code by making the 2009 estate tax parameters permanent, exempting estates of up to $7 million for a married couple," Mr. Furman says. The Obama plan "retains the estate tax for the top 0.3% of estates in order to restore fairness to the tax system, helping to pay for a tax cut for 95% of workers and their families."

The McCain Plan. Sen. McCain proposes raising the exclusion to $5 million per person and cutting the top federal estate-tax rate to 15%, says Douglas Holtz-Eakin, the senator's senior policy adviser and a former director of the Congressional Budget Office. This plan "should go into place ASAP after he is elected," Mr. Holtz-Eakin says.

"If the political climate makes it next to impossible to achieve full repeal, then Congress should look towards a compromise," says Mr. Holtz-Eakin, referring to President Bush's unsuccessful efforts to kill the estate tax permanently. He calls Sen. McCain's plan "a compromise that holds the potential for breaking the logjam and providing some much-needed certainty."

Cutting the tax rate to 15% "would link the death tax with the current capital-gains tax rate," Mr. Holtz-Eakin says. "By doing so, Americans will not be forced to pay more in death than they would if they had sold property prior to their death." He also says that a $5 million exclusion "is generally thought by many to be the appropriate size to help small-business owners avoid cash-flow difficulties" upon the death of a family member.

Stepping Up. Despite their differences, both senators support retaining the current system for valuing stocks, mutual-fund shares and other inherited property whose value has increased over the years. This is important to many heirs because it can affect how much they eventually owe in capital-gains tax, if anything at all, when they sell inherited property.

Suppose your aunt dies and leaves you an assortment of stocks and fund shares that have risen sharply in value over the years. Under the current system, your cost "basis" for purposes of calculating future taxes would typically be their value on the date of her death (or, in certain circumstances, six months later). This system often is referred to as "stepped-up basis" or "step-up in basis," since the value of the appreciated asset typically gets stepped up to fair market value. The current step-up system is scheduled to continue through 2009, and then undergo major changes in 2010.

What You Could Pay. Under both candidates' plans, very few estates would have to pay federal estate tax. How much heirs ultimately pay could vary widely depending on such factors as state tax laws. But the McCain plan, if enacted, generally would mean much-larger savings for heirs of substantial estates than the Obama plan.

Heirs to the biggest fortunes should care far more about what happens to the tax rate than the exclusion amount. "The wealthiest Americans would benefit more from McCain's tax-rate decrease than from his exemption increase," says John Olivieri, a partner at the law firm White & Case in New York.

Analysts at Deloitte Tax estimate the federal estate tax for a hypothetical $5 million estate under the McCain plan would be $675,000 less for 2009 than under the Obama plan. For a $10 million estate, the savings under the McCain plan would be nearly $2.2 million. For a $50 million estate, the difference would be more than $14 million. For a $100 million estate, the difference would be more than $29 million. (These numbers reflect federal tax only; many states levy their own taxes.)

Getting Ready. Besides staying in good health, consider a few other ideas. For starters, make sure you have all your key documents in place and up to date, such as your will, durable power of attorney, health-care proxy and living will, says Mr. Olivieri. "An up-to-date will should contain a plan flexible enough to deal with the changing tax landscape," he says. Also make sure those you trust know where all these documents are located.

One of the easiest techniques is to take advantage of the annual gift-tax exclusion. That allows you to give away as much as $12,000 a year to anyone you wish -- and to as many people as you want -- without having to worry about taxes or even file a return. In addition, you can pay someone else's tuition or medical expenses without having those payments count toward the annual limit -- as long as you make your payments directly to the educational or medical institutions. Many wealthy people use the gift-tax exclusion to reduce the size of their taxable estates.

There are many other techniques worth considering, including setting up various types of trusts, such as a "grantor-retained annuity trust," or GRAT, says Don Weigandt, a managing director of J.P. Morgan Private Bank in Los Angeles. This type of trust is popular among those with assets expected to increase in value. Another idea: Consider moving from a high-tax state, such as New York or New Jersey, to one such as Florida or Nevada.