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Estate Tax Gets a Year Off, but the IRS Will Still Reap Grimly

As April 15 approaches, MoneyWatch is publishing a tax tip of the day. Please check back each morning for the latest advice from our experts.
There's no federal estate tax for 2010, so dying before the year is out, while not without its down side, will put your heirs in a better financial position, right?

Not necessarily. The absence of a direct tax on inherited wealth has created two potentially costly paradoxes for estate planners and their clients: It may be more difficult for people to pass assets on as they intend, and smaller fortunes may generate greater tax liability without the estate tax than with it.

When there is an estate tax, it always comes with an exemption; next year it will be $1 million plus anything left to a spouse. An immense 55 percent of any surplus goes to the Internal Revenue Service, but estates worth less than the exempt amount get passed on free and clear.

Now comes the big un-loophole: The tax is taking a one-year break, but as part of the compromise that did away with it, the liability for capital gains tax on inherited assets was raised substantially. That is likely to create adverse consequences this year for heirs of smaller estates.

When an estate tax is in effect, the cost basis for inherited assets - the price at which they are deemed to have been acquired for figuring capital gains - is their value when the person bequeathing them dies. That so-called step-up, along with the estate tax, has been given the year off.

That means that people who saved judiciously and built investment portfolios, buying and holding assets for long periods - just as they were rightly encouraged to do - could also be passing whopping tax bills on to their loved ones.

Perhaps not as costly but just as confusing, the estate tax hiatus renders the wording in many wills problematic. To benefit from exemptions, it's common to leave children "the maximum amount I can shelter from federal estate tax" instead of a specific figure, with the rest going to the spouse. With no estate tax, however, every penny is sheltered, so the spouse would be left high and dry.

Estate planners advise reading over wills to ensure that they are written in a way that will limit hassles for heirs. Even when the rules related to inheritance are not in flux, it makes sense to peruse documents from time to time, said Elizabeth Ruch, a financial planner at the investment firm Waddell & Reed.

"Every estate plan should be reviewed every four or five years," she said. "Make sure everything's relevant, with the right beneficiaries in place. Know what you want to do and why you want to do it."

One thing the moderately well-off will want to do is avoid the harsher tax treatment to which their estates are susceptible this year. There is one sure way to do it: Stay alive at least until New Year's Day.

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