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Liz Pulliam Weston

The Basics

5 estate-tax myths that won't die

Yes, it's going away, but you can be certain it will be back -- and that the same old arguments will arise. Here are the facts about the controversial tax.

By Liz Pulliam Weston
MSN Money

Permanent estate-tax repeal is officially dead. With huge deficits to cover, the argument now is about the size of estates that will escape tax and how much that tax will be.

Currently, the estate tax is scheduled to disappear next year and then spring back to life, phoenix-like, in 2011. The top options under consideration are to:

  • Make permanent the 2011 exemption, in which estates under $1 million escape taxation and the top tax rate is 55%.

  • Make permanent this year's $3.5 million exemption and 45% tax rate.

  • Index the $3.5 million exemption to inflation and cap the tax rate at 45%, which is President Barack Obama's proposal.

  • Raise the exemption to $5 million and cap the tax rate at 35%, as proposed by Sens. Blanche Lincoln, D-Ark., and Jon Kyl, R-Ariz.

Now, reasonable people can disagree about which proposal is best, just as they disagreed about whether we should have an estate tax in the first place.

Good arguments, though, require good information. Bad information distorts the debate, and there's far too much of the latter floating around about the estate-tax system. Here are some of the most persistent and misleading myths:

Myth No. 1: Lots of people face the federal estate tax.

Even before Congress raised estate-tax exemption limits starting in 2002, relatively few estates paid taxes.

Only 2% of the 2.4 million people who died in 2001, or fewer than 52,000 estates, left behind enough wealth to owe estate taxes, according to the Internal Revenue Service.

That was back when any estate worth more than $675,000 had to file an estate-tax return. Since then, the estate-tax exemption limit has been raised substantially, starting at $1 million in 2002 and rising to $3.5 million for 2009. Right now, the limit is scheduled to disappear for 2010 and return at $1 million for 2011.

If the estate-tax exemption were fixed at $1 million, about 46,000 estates would owe tax annually, according to the Tax Policy Center, a nonpartisan joint venture of the Urban Institute and the Brookings Institution.

Raising the exemption to $3.5 million would reduce the number of taxable estates to 6,410 a year, the center found. Indexing it to inflation, as the White House proposes, would shrink the number to 6,160, while the $5 million exemption proposal would reduce the number even further, to 3,600.

And the vast majority of the taxes owed would be paid by huge estates. Under Obama's plan, for example, 84% of the total taxes owed would be paid by estates worth more than $10 million, said Leonard Burman, the center's director and a former senior analyst for the Congressional Budget Office. The average estate-tax bill would be about $3 million, or 19% of total estate value.

The bottom line: The estate tax is indeed an expensive problem for those who have to face it, but its direct impact is far from widespread.

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Abolish the 'death tax'? © Jack Hollingsworth / Getty Images
Abolish the 'death tax'?
Experts discuss whether the estate tax should be eliminated.
Myth No. 2: Average families are taxed twice.

The estate tax is indeed a kind of double tax on wealthy families, because income or other taxes may have already been paid on money or assets that are then taxed again at death.

But most families get a big tax windfall when someone dies and passes assets on to heirs. That's because of a tax break known as a step-up in basis.

Essentially, the property and most investments in an estate get a new value for tax purposes when someone dies. It's this value that the heirs use to determine their taxable profit when the property or investments are sold.

Here's how it works. Say your folks paid $20,000 for a house that was worth $200,000 on the day your last parent died. Without the step-up, you'd have to pay capital gains tax on that $180,000 increase in value if you sold the property. Thanks to the step-up, however, the house gets a new basis of $200,000. If you sold it for $200,000, you wouldn't owe any capital gains tax.

Estates get this special tax bonus whether or not they pay any estate tax. For the vast majority of people, that means the increase in value of their estates never gets taxed, either when they die or when the property they bequeath to others is ultimately sold.

The bottom line: The current estate tax system benefits far more families than it penalizes.

Continued: Can the tax be avoided?

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