The new, more generous estate-tax rules are welcome improvements, but could require some adjustments to your plan.

If you've been doing a little estate planning over the past few years, chances are you breathed a little sigh of relief when you sipped your champagne this past New Year's Eve.

To be brutally blunt: Dying in 2004 and 2005 will be a less taxing event than it was in 2003. That's because effective last Jan. 1, the federal estate-tax exemption jumped to $1.5 million from $1 million. This improved $1.5 million break applies to anyone who dies in 2004 or 2005. So you can shelter up to $500,000 more ($1 million more if you're married) from any federal estate-tax hit than if you had passed away last year. Yup, this is morbid. But it's welcome news to your heirs.

That said, you need to be careful. This leap in the exemption could throw your estate plan out of whack. Without a careful review of your arrangements, part of your estate could be allocated in ways you didn't intend.

I'll go over some of the potential danger zones, and offer some solutions. But before I do that, let me just make a plea to all of you who took a look at that $1.5 million figure and figured this article definitely does not apply to you. Sure, $1.5 million sounds like an awful lot of money. But you just might be a whole lot wealthier than you think. For federal estate-tax purposes, your estate includes your home, cars, retirement accounts, taxable investment accounts, collectibles and so forth.

Perhaps more important, it also includes any death benefits from personal life-insurance policies you own. (If you have the power to change beneficiaries or coverage amounts, you own the policy.) With life-insurance coverage thrown into the mix, the odds are good that your estate exceeds the seemingly generous $1.5 million exemption. So if you don't already have an estate-tax savings strategy in place, now may be the time to create one. For assistance in getting started with an estate plan, click here.

And for those who do already have an existing estate plan, here's a review of how the new rules could affect you — along with some advice on how to fix things.

Problem #1: Your Current Plan May Funnel Too Much — or Not Enough — Into Your Bypass Trust
If you're married, your current estate plan may include a bypass trust arrangement. This common estate-planning tool is used to ensure that both you and your spouse take full advantage of your respective estate-tax exemptions. The way most plans work is that an amount equal to the current federal estate-tax exemption automatically goes to fund a bypass trust when the first spouse dies. Typically, the trust beneficiaries are the children of that spouse. (For a more detailed explanation of these trusts, click here.)

Since you name the beneficiaries of the bypass trust that arises if you are the first to die, the amount used to fund the trust is included in your gross estate for federal estate-tax purposes. However, that amount is then fully sheltered by your estate-tax exemption. The result: no federal estate-tax bill. So far, so good.

But here's the rub: Many wills don't state a specific figure for the amount going to fund the bypass trust. It's just whatever current federal tax law provides as the exemption amount. But with the exemption suddenly jumping to $1.5 million from $1 million last Jan. 1, your bypass trust could wind up with a lot more money than you intended. That means your spouse could come away with a lot less than you wanted.

For example, say you have a $2.1 million estate. Your will stipulates that a bypass trust is to be funded with an amount equal to the current federal estate-tax exemption if you die before your spouse. So if you depart this year or next year, a whopping $1.5 million would automatically funnel into the trust. Your spouse would get the remainder of your estate, which would be only $600,000 ($2.1 million estate reduced by $1.5 million to fund the bypass trust), whereas under the 2003 rules, your spouse would have received $1.1 million.

While your spouse can technically gain access to the bypass trust money to meet his or her reasonable financial needs, it doesn't make any sense to leave the window open for future problems when it's so easy to close it. Worst-case scenario: Your spouse could get into a legal hassle with your kids regarding what's "reasonable." Even in the best-case scenario, your spouse may be forced to ask the kids for permission to dip into the bypass trust. That could create a sweaty situation for all concerned, particularly if your children are from a previous marriage.

Solution: Revise your will to stipulate a specific figure to fund the bypass trust should you die before your spouse in 2004 or 2005.

On the flip side, if your current estate plan already stipulates a specific dollar amount to fund the bypass trust, you might have exactly the opposite problem: too little money going into the bypass trust. For example, say you have the same $2.1 million estate. Your current will stipulates that if you die before your spouse, $1 million (the old-law exemption amount for 2002 and 2003) would automatically flow into the trust. Your spouse would get the remaining $1.1 million ($2.1 million estate reduced by $1 million to fund the bypass trust). But she may not need or want all that money if she has a substantial estate in her own right. And while it used to make sense to use that figure since it avoided an estate-tax hit, now it no longer makes sense.

Solution: Amend your will to say the bypass trust will be funded with the upgraded $1.5 million amount if you die before your spouse in 2004 or 2005. Under the amended plan, your kids would get $1.5 million — instead of just $1 million — free of any federal estate-tax hit. Plus your full $1.5 million exemption would be utilized instead of partially going to waste.

Problem #2: Unmarried? Your Current Plan May Leave Too Much to Charity
If you're single, you also need to do some planning if your estate is worth over $1.5 million — that is, unless you want Uncle Sam to be one of your main beneficiaries. (Surely you can find someone better to leave the money to than that.) For example, you might want to leave just enough to charity to reduce your taxable estate to the magic $1.5 million figure should you die in 2004 or 2005. That way, the expanded $1.5 exemption would wipe out any federal estate-tax bill.

But beware: Your existing will might call for leaving just enough to charity to reduce your estate to the old-law exemption amount of $1 million.

Solution: If you like, you can now leave $500,000 more to friends and relatives (and $500,000 less to charity) while still leaving zero to the U.S. Treasury. Keep in mind, I'm not advising you to leave less to charity. I'm just suggesting you now have the option of leaving more to friends and relatives without triggering a federal estate tax bill.

Problem #3: Your Current Plan for the Home May Be Sub-Optimal
If you have a pricey home, the newly expanded federal estate-tax exemption may suggest another change to your existing plan. Say your home is worth $1.5 million. Your current will may leave the property to your spouse rather than your kids because, up until Jan. 1, 2004 leaving the house to your children would have triggered a substantial estate tax hit. Until this year, many married couples did this and then left liquid assets to the kids. They did this despite the fact that if one spouse were to die, chances are the house would soon have been sold, anyway.

Solution: Thanks to the expanded exemption, you can now leave the $1.5 million house to your kids federal-estate-tax free. Then you can generally leave all your liquid assets federal-estate-tax free to your spouse by taking advantage of the unlimited marital deduction. Depending on family circumstances, that could be a much better deal for all concerned. (It does, however, leave the door open for the kids to kick the surviving spouse out of the home. Needless to say, if this unpleasant scenario is a possibility in your family, you might want to think twice about this strategy.)

As a bonus, the tax basis of the home would be "stepped up" to its date-of-death fair-market value. So your kids could later sell the house for $1.5 million without owing a dime in federal capital-gains taxes, even if your basis in the property was a really low number. So with this maneuver you could have no estate tax, no capital gains tax, all your heirs taken care of and an appreciating asset removed from both your estate and your spouse's estate. Not bad.

The Current Shape of the Federal Estate Tax
Until 2010, the federal estate tax will remain in existence. Starting this year, expanded exemption amounts begin kicking in. Also, the maximum tax rate will continue to drop over the next few years before fading out completely in 2010.

That's how the law reads right now. I personally doubt you will ever see the promised repeal even for one year. I also doubt the estate tax situation in 2011 will be as bad as scheduled. Bet on Congress to permanently install a $3 million to $5 million exemption sometime before 2010.

In any case, here's a breakdown of the current rules: