This a tax trap that robs the hard-earned assets of many unsuspecting Americans. Bill and Mary Jones are worth about $625,000. Bill dies and his will leaves "everything to Mary." Mary lives another 10 years.
During that time, her assets grow at an annual rate of 7 percent and, thereby, double in value. When Mary dies, her will leaves everything to her children . . . or nearly everything. You see, nearly $250,000 of the estate will go to the IRS before the children see a dime! That is a tax trap that Bill and Mary fell into not knowing that they were wasting a tax exemption of $625,000.Bill and Mary are real people. We simply changed their names to protect our clients. We meet with clients all the time who have no idea of the tax trap that awaits them. One couple, for example, was worth about $3,000,000 when they met us, and they had never heard of estate taxes.
Without estate planning, over $1,000,000 of their assets would have been paid to the government in the form of estate taxes when they died. Another couple, worth far less than that, was outraged to learn that the government would tax their children's inheritance without disclosing that the taxes could legally be minimized or eliminated.
Here is the tax we're talking about. It has two names: gift tax and estate tax. Both are taxes charged when you try to transfer assets to someone other than your spouse. Gift taxes are assessed on lifetime transfers; estate taxes are charged when you give away assets at your death.
Current tax laws say that an individual can give away $10,000 per year with no gift tax, and that gift can be made to as many different people as you want. In addition to that annual gift tax exemption, you can give away another $625,000 (made up of combined lifetime and at-death gifts). That exemption is available once-in-a-lifetime.
Let's go back to Bill and Mary Jones. I said that the trap that Bill and Mary got into was unknowingly wasting a tax exemption of $625,000.
You see, Bill and Mary could have utilized two $625,000 exemptions totaling $1,250,000, but they wasted one exemption. Had Bill and Mary not wasted an exemption, Mary's entire estate of $1,250,000 would have been exempt from gift and estate taxes. Bill and Mary would have kept $250,000 in the family instead of it being mailed to the IRS as a tax check. Here's where Bill and Mary made their mistake.
When Bill passed away, his will left everything he owned to Mary.
Because of a tax law that provides an unlimited deduction to a spouse transferring assets to another spouse, all of Bill's assets passed to Mary tax free. Consequently, everything that Bill left to Mary passed to her tax free, but then Mary ended up with too much in her taxable estate. She was left with an estate of $1,250,000 but an exemption of only $625,000. One half of Mary's estate was left unprotected and subject to tax.
The estate-planning tool that is frequently used by a married couple, to ensure that they utilize both $625,000 tax exemptions, is called a credit-shelter trust. The trust goes by other names such as a "family" trust, a "bypass" trust, and a "B" trust within an A-B trust arrangement. Whatever the trust is named, it is designed to utilize the $625,000 exemption of both spouses and not allow one of the exemptions to be wasted. Such a trust can be created within a Revocable Living Trust or within a testamentary will.
On June 28 I will explain how both of the tax exemptions for Bill and Mary could have been utilized by means of a properly drafted will or trust.