NEW YORK - Financial experts think 2010 could provide many interesting opportunities in the realm of wealth transference, particularly with the temporary, one-year expiration of the federal estate tax and reduction of the gift tax.
Thanks to the expiration of the estate tax on Jan. 1, beneficiaries of people who die this year don't have to pay federal taxes on inherited estates. Unless Congress takes action this year, the tax will be reinstated in 2011 to 2001 levels of a $1 million exemption and 55% tax rate above that. President Barack Obama has proposed reinstating the tax at 2009 levels of 45% on anything above $3.5 million, possibly retroactively.
"We recommend that affluent investors revisit their wills this year," said Carol Kroch, managing director of charitable trusts and head of wealth and financial planning, at Wilmington Trust's Wealth Advisory Services.
Kroch said a common formula in wills gives the children of the deceased the maximum amount allowed before the federal estate tax is triggered, with the remainder going to the spouse of the deceased. If there is no estate tax, like this year, this could be interpreted to mean all the estate would go to the children and the spouse of the deceased would receive nothing.
"There are cases where people are unintentionally disinheriting their spouses, children or grandchildren," she said.
The purpose of an estate tax - also known as the death tax - is to prevent a small number of extremely wealthy families from passing on their wealth and property tax-free to future generations in perpetuity and creating an aristocracy of what Winston Churchill famously referred to as the "idle rich."
The tax was always intended to target "old money," ultra-high-net-worth individuals, but a million dollars doesn't buy what it used to.
The children of the Great Depression became lifelong savers and are now passing on a huge amount of collective wealth to the Baby Boomer generation, some of whom are already retired. Real estate purchased decades ago may easily be worth $1 million or more and hardly qualifies as old money.
Congress realized this when it passed the Economic Growth and Tax Relief Reconciliation Act of 2001 and set up the estate tax to gradually increase the maximum tax-exempt sum over the years. Congress had planned to renew the tax before it expired at the end of last year, but a combination of politics and procrastination thwarted this effort.
Legislators could still pass a retroactive estate tax that would be effective back to Jan. 1, 2010, further confusing wealth planning efforts.
The gift tax - a cap on the annual and lifetime amount of tax-exempt gifts - was created to dissuade wealthy individuals from sidestepping the estate tax by giving away their money to family members. Annual gifts to family members are commonly used to decrease the value of the estate prior to the owner's death and lower the future estate tax burden on the beneficiaries. Currently individuals can give away $13,000 to as many people as they want tax-free, per year, up to a lifetime amount of $1 million.
The gift tax is typically 45% of the amount over $1 million, but Kroch said the gift tax is lower this year, at 35% over $1 million. Next year it will go to 55% over $1 million.
Kroch said 2010 may be a good year for affluent individuals to make gifts to their heirs, but added that they should seek legal counsel prior to such a move, due to the complicated, changing nature of the rules.
There are many idiosyncrasies in the federal tax laws that allow wealthy families to skirt paying estate and gift taxes by establishing trusts, creating charities or designating their property as a family farm, but legal experts stress that state laws differ and should be taken into consideration.
Many states allow parents to give their children a set amount of tax-free income each year to purchase life insurance in the event of the parents' early death, and affluent parents have the ability to give loans to children or to a trust in their child's name that can collect earnings over time that don't trigger the gift or estate taxes.
"There are so many factors and no clear rules," Kroch said. "Six weeks ago, nobody would have said a repeal of the estate tax was possible, but here we are. Now, the Democrats have lost their [filibuster-proof] majority. Anything could happen at this point."
She said a number of states have taken a legal approach to decide the terms and meaning of wills, and said Florida is suggesting that beneficiaries be empowered to go to court.
"This is a lot of complexity for families to manage. It's going to be complicated and it's continually changing."
She said Congressional repeal may not happen until after the November election, as legislators seek to placate their biggest donors.
"This is not a time to bet big. It's a time to cover your bases and play good defense," said Rex Macey, chief investment officer at Wilmington Trust Investment Management. "Investors must allow for a wide range of outcomes with respect to how the economy recovers and the financial markets' reaction."
Macey said Wilmington Trust is taking a seven-year forecast that predicts a likelihood of single-digit annual returns and modest inflation levels. He said the array of possible economic and financial market outcomes is wider than usual in the wake of the deepest economic downturn in several generations.
"We find it counterproductive to take too short a timeframe," he said. "The federal stimulus program may work, but we could also see a double-dip recession or stagflation."
He said higher interest rates could lower bond yields, and high-yield bonds, combined with emerging markets, could be a smart combination.
"Given today's uncertainties, we believe it's smart to follow the advice of Nobel Prize-winning economist Harry Markowitz, who reminds us that a good portfolio is more than a list of stocks and bonds; it is a balanced whole that provides an investor with protections and opportunities in the face of a wide range of contingencies," he said.
Emerging markets continue to look attractive relative to more established global markets, he said, and developing markets like China and India are beginning to decouple from the U.S. economy, possibly insulating them from domestic market downdrafts.
"Investors must be careful to ensure that they do not outspend what we are likely to see in the way of investment returns over the next several years," Macey said. "As always, prudence and patience will prove to be virtues."
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