Give Your Estate Plan a Year-End Checkup

New, more generous rules take effect on Jan. 1. Fixing your will now could save your heirs tons of taxes.

Over the past couple of months, many of the tax pros I know have seen a sudden surge of interest in estate planning. That's not surprising: The events of Sept. 11 made us all painfully aware of our own mortality. And having your estate plan in order is an essential part of making sure your loved ones are provided for.

Of course, I consider you my clients. So it's time for an appointment. Not only may estate-planning issues be on your mind during this era of "the new normal," but the fact is, a whole bunch of new (and more generous) estate- and gift-tax rules will kick in on Jan 1. (See the sidebar for a quick summary of the new guidelines.) So now's the time to start revising your paperwork.

Married Couples
If you're married, you most likely have a will. (If you don't, you should. Click here for an article on how to write a simple one.) But married couples with a healthy net worth of $1 million or more (including life-insurance coverage) should also generally have bypass-trust language included in their wills. The bypass-trust arrangement ensures that both spouses can take advantage of their respective estate-tax exemptions, regardless of who dies first. In other words, rather than leaving everything to your spouse, which leaves you with one exemption worth $1 million (in 2002), you can make sure that you each get your respective exemption, thus shielding $2 million from estate taxes.

In brief, here's how a bypass trust works. Each spouse's will stipulates that a certain amount will be used to fund a bypass trust if that person is the first to die. In other words, your personal bypass trust (you and your spouse each have your own) actually comes into existence only if you're the first to go. You and your spouse each name your own beneficiaries for your respective trusts (usually your children). And the fact that you name the beneficiaries means the amount used to fund the trust is included in your estate for federal estate-tax purposes.

The amount going into the trust is sheltered by your estate-tax exemption, which is $675,000 for 2001 and rises to $1 million in 2002. This is good news, of course, but if you don't revise your paperwork, it could cause problems for your surviving spouse. Why? Because many existing bypass trusts include language that call for the trust to automatically be funded with "an amount equal to the current-law federal estate-tax exemption," or something to that effect, without any specific number being mentioned. What does this really mean? With the exemption escalating to $1 million from $675,000 literally overnight, your spouse could be seriously shortchanged if you die after this year without adjusting your will. In other words, too much money might automatically go into the bypass trust, leaving too little to go directly to your surviving spouse.

While a surviving spouse has the legal right to dip into the bypass trust to meet reasonable expenses, it's obviously best to avoid potential hassles by leaving enough money directly to the spouse. This is especially true when the beneficiaries of your bypass trust are children from an earlier marriage or someone else who might not have a close relationship with your spouse.

For example, say you have a $1.65 million estate. Your spouse has only modest assets. Your current will, which was written a few years ago when the estate-tax exemption was slated to rise to $700,000 in 2002, says that when you die an amount equal to the federal estate-tax exemption goes into a bypass trust set up to benefit your kids. So if you pass away in 2002 without making any changes, a cool $1 million goes straight into the trust, with only $650,000 going to your spouse. That might be far less than you intended for him or her. And since the exemption will increase to $2 million in 2006, your spouse could end up with zip.

Year-End Planning Move: In this scenario, your will should be revised before Dec. 31 to stipulate a specific amount to fund your bypass trust. For example, you may decide to fund the trust with the originally intended $700,000. That allows you to leave $950,000 directly to your spouse.

Very Wealthy Married Couples
But what if your bypass trust does identify a specific dollar amount? This also could cause a major headache, although it's most likely only a potential problem for wealthier folks (i.e., each spouse has assets of $1 million or more).

Say your will contains a schedule of specific dollar figures to fund your bypass trust depending on which year you die. However, the stipulated amount is based on the old-law federal estate-tax exemption of $700,000, which is far smaller than the $1 million you're now entitled to. In this case, you can wind up with too little money being directed into your bypass trust. That means you'll fail to take advantage of the expanded estate-tax exemption, which could result in hard-earned dollars going to the IRS instead of your heirs.

For example, say you have an estate worth $1 million or more. Your spouse is financially independent and really doesn't need or want any money from your estate. In this scenario, your primary tax-planning objective is to take full advantage of your expanded estate-tax exemption. However, your current will stipulates that if you die in 2002, exactly $700,000 will go into a bypass trust set up to benefit your children. So $300,000 worth of estate-tax shelter could go up in smoke simply because your trust language is obsolete. Meanwhile, your kids, who could really use the extra $300,000, won't get it if you die without making a change. The same suboptimal results could occur if your current will calls for $700,000 to go directly to your children if you die in 2002.

Year-End Planning Move
Before Dec. 31, amend your will to leave $1 million to your kids (either via a bypass trust or directly). By making this simple fix, you'll lock in the full benefit of the expanded estate-tax exemption.

Singles
Unmarried taxpayers don't need bypass trusts to take full advantage of their estate-tax exemptions, since they're working with only one estate-tax exemption. Nevertheless, given the expanded exemption taking effect on Jan. 1, single folks might want to rethink how they're disposing of their assets.

Effective Jan. 1, 2002, a single person can leave bequests of up to a total of $1 million to one or more individuals free of any federal estate tax. These can be relatives, friends, whomever. Of course, before the new tax law, the 2002 figure was set to be a comparatively paltry $700,000. So say you have a $1.5 million estate. Your current will might leave $700,000 to individuals if you die in 2002. To avoid any federal estate-tax hit under the old law, the remaining $800,000 is directed to several of your favorite charities.

Year-End Planning Move: Since the new law allows you to leave up to $1 million estate-tax free if you die in 2002, you might want to rethink your will. You might, for example, want to give the additional $300,000 to a person, rather than a charity, while giving the amount that would otherwise be subject to estate taxes (in this case, that would be $500,000) to a tax-exempt charity. Once again, this action should be taken before Dec. 31. (Please understand that I'm not discouraging charitable intent here; I just want you to understand your options under the new law.)

Don't Wait
This article explains a few common situations in which estate-tax changes mandate amending your will before year end. Naturally, there are many others. The higher your net worth and the more complicated your financial picture, the more likely your existing estate plan needs an immediate overhaul. I suggest you get started pronto, because your friendly estate-planning professional will probably be swamped trying to help people like you before the looming deadline.