There will be major changes in many estate plans in 2009. This year will see the largest ever year-to-year increase in the federal estate-tax exemption, and it comes at a time when many estate values have decreased due to the housing and stock market declines. Therefore, every estate plan needs to be reviewed to make sure it is still relevant and that surviving spouses do not end up receiving less than they thought. In addition, advisors need to be aware of potential higher state estate taxes in states that have decoupled from the federal estate-tax system.

The Background

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) contained many changes that are still phasing in. In 2009, the estate-tax exemption rises from $2 million to $3.5 million. Under current law, the estate tax is to end in 2010, but is to come back as a $1 million exemption in 2011.

For now, let's look at the $3.5 million exemption, as it's unlikely that the 2010 estate-tax repeal will materialize. Instead, it is more likely that the $3.5 million exemption (or an amount close to that) will stay in place for several years.

A married couple now has $7 million of estate-tax protection if the estate plan is set up to take advantage of each spouse's $3.5 million exemption. The increase should eliminate estate tax for millions more families who may have been subject to the tax when the exemption was lower. This paves the way for larger IRA amounts to pass to children and other beneficiaries, estate tax-free.

Although most spouse beneficiaries can inherit an unlimited amount of property through the marital deduction, leaving everything to a spouse is not always the best move, especially for larger estates that could be subject to estate tax when that second spouse dies.

The same $3.5 million exemption applies to the generation-skipping transfer (GST) tax, which makes the stretch IRA more powerful. Beginning in 2009, clients can leave more of their IRAs or Roth IRAs, free of any GST tax, to grandchildren. Their longer life expectancies will allow the IRAs to grow tax-deferred or even tax-free (with a Roth IRA) for greater wealth buildup over time in stretch IRAs.

Gift Tax Vs. Estate Tax

Although the estate and GST tax exemptions increase to $3.5 million, the lifetime gift-tax exemption remains at $1 million. The gap between the gift tax and the estate tax increased from $1 million in 2008 to $2.5 million in 2009.

This gap puts a damper on doing any gifting that would trigger a gift tax, especially if the property would have been exempt from estate tax after death. But making gifts up to the $1 million gift-tax exemption is still a viable strategy, since the tax cost of gifting is still less than the tax cost of inheriting.

The annual gift-tax exclusion also increased this year to $13,000 a year from $12,000 in 2008. Clients can now give up to $13,000 a year to as many people as they wish, completely free of any gift tax. If your client is married and his or her spouse agrees to join, the two can double the exclusion to $26,000 per year to an unlimited number of people (known as gift splitting). While the increase in the federal estate-tax exemption is good news, it could trigger two problems if planning is not addressed: A spouse could receive less, or there could be an increase in state estate taxes.

What Goes to the Spouse

If a client is married and has set up a typical credit shelter trust estate plan (also known as a bypass trust), now is the time to review that plan. Under this type of estate plan, amounts up to the federal estate exemption ($3.5 million in 2009) will go to the credit shelter trust. Any excess over that amount will either go directly to the spouse or to a marital trust for the spouse's benefit.

In a perfect estate plan, each spouse would use his or her entire exemption amount, paying the lowest possible estate tax after both spouses die. But for many couples, this plan was set up when the estate exemption was much lower.

Many estate plans have credit shelter trusts that were set up when the exemption was $2 million (some even have plans set up when the exemption was $600,000). If the plan was set up when the exemption was $2 million and the estate was $4 million, that would have been perfect, since $2 million would go to the credit shelter trust (using the first spouse's $2 million exemption) and the other $2 million would go to the surviving spouse. When that spouse died (assuming the estate at death was $2 million), his or her $2 million exemption would be used, so the couple would pass their entire $4 million estate to their heirs free of federal estate tax.