Federal government exemptions can save assets

Key Points

The law provides an unlimited marital deduction, so spouses can transfer assets to each other without incurring estate or gift tax. Therefore, if the first spouse to die gives all of his or her assets to his or her surviving spouse, his or her estate will not pay any estate or gift tax. Typically, these assets will be held in a "marital deduction trust." Without proper planning, however, upon the death of the surviving spouse, there typically will be a large amount of estate tax owed if the assets of the surviving spouse and marital deduction trust assets exceed the estate tax exemption. Therefore, it is essential to correctly use the unlimited marital deduction and the estate tax exemption.

Gifts also may be subject to federal estate tax if they do not qualify for the annual exclusion (currently $13,000 per recipient per year), the tuition and medical direct payment exclusion, the marital exclusion, or the charitable exclusion. Lifetime gifts that do not qualify for any of these exclusions are "taxable gifts." Taxable gifts that use some of a taxpayer's gift tax exemption also reduce a taxpayer's estate tax exemption by the same amount.

If a person makes cumulative taxable gifts in excess of the lifetime gifting exemption, which stayed at $1 million from 2002 through 2010, then such gifts will be subject to federal gift tax. They would have triggered a gift tax at a rate of 45% for years 2007 through 2010. Before 2007, the gift tax rate had been as high as 55% for gifts made after 1984.

Here's an example of how the system works: If a father gave his daughter gifts equal to the annual exclusion each year plus additional gifts of $900,000 through 2009, then the father has used $900,000 of his $1 million gift and estate tax exemption. If the father died in 2009, then upon his death he could have transferred $2.6 million ($3.5 million - $900,000) without payment of estate tax.

For 2011, the gift and estate tax exemption was $5 million. For 2012, this amount has been adjusted for inflation and is $5.12 million. But under the current law, the exemption for gift tax and estate tax will revert to $1 million on January 1, 2013.

As a result of this $5.12 million temporary opportunity, many financially successful individuals are funding trusts for spouses and family members, taking advantage of the chance to gift more than $1 million if it fits in with the family's financial and retirement planning.

For example, the generous new exemption amount permits the father who had given his daughter gifts equal to the annual exclusion each year plus $900,000 the ability to gift an additional $4.22 million ($5.12 million - $900,000) without paying any gift tax. If the January 1, 2013, $1 million exclusion amounts rear their ugly heads, then this person will have successfully transferred $4.12 million out of his estate, plus the growth thereon, without paying any transfer taxes. If this person waits until 2013, he will be limited to gifting only $1 million without incurring transfer taxes.