5 big myths about the estate tax

By Liz Pulliam Weston

Reasonable people can disagree about whether the United States should have an estate tax. There are good arguments both for and against.

Good arguments, though, require good information. Bad information distorts the debate, and there's far too much 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

Of the 2.4 million people who died in 2001, exactly 51,841 estates (2% of the total) faced a federal estate tax, according to recent IRS figures.

Slightly more than twice that number of estates, 108,112, had to file estate-tax returns, which were required that year for gross estates worth more than $675,000. (That estate-tax exemption limit has since been raised in steps; it was $1.5 million for 2004 and 2005, and rises to $2 million for 2006, 2007 and 2008.) But 56,271 of those who filed returns didn't owe any federal estate tax, typically because they left everything to surviving spouses (see below) or because their debts, death-related costs and gifts to charity lowered their gross estate below the limit where taxes are required.

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

Myth No. 2: Federal repeal has ended death taxes

The estate tax is scheduled to phase out, then disappear for one year -- 2010 -- and then spring back to life, phoenix-like, in 2011. That's because Congress was trying to limit the cost of the repeal when the legislation was enacted in 2001.

President Bush wants to make the repeal permanent, and the House has agreed. But the idea faces tough opposition.

Even if Congress succeeds in doing away with the federal estate tax, other death taxes will almost certainly survive. Some states currently impose their own levies on estates or inheritors. Many states that didn't charge estates before the 2001 act have since enacted death taxes to try to make up for lost revenue. (See "The 'death tax' is far from dead.")

Then there's probate, the court process that typically follows death. Probate is different from estate taxes, but it imposes costs just the same and usually on much smaller estates, sometimes as small as $20,000.

The bottom line: Those who oppose death taxes shouldn't think the battle is over, either now or if the repeal is made permanent.

Myth No. 3: The tax can be avoided

Estate planning can reduce the tax bite. If you're rich enough, however, your estate will eventually face taxes unless:

• You die in 2010, the one year in which the estate tax is scheduled to be totally repealed, or

• You give everything to charity, or

• You give everything to your spouse

Surviving spouses get what's known as the "unlimited marital deduction," which means that anything left to them escapes the federal estate tax. That's a good deal, of course, but presents problems if you want to make sure that your money eventually gets to your children or grandchildren. Your spouse could blow the money or run off with a personal trainer, which means the trainer's kids, rather than yours, could wind up with your estate. Even if your spouse is a good steward, a large enough estate will face the tax when he or she eventually dies.

If the estate tax could be entirely avoided, then you would figure the richest of the rich would find ways to do it. In fact, the 469 largest taxable estates in 2001 -- those worth $20 million and up -- faced a net average tax of $10.4 million each.

The bottom line: The estate tax isn't one of those levies that only the stupid pay.

Myth No. 4: The tax costs more to collect than it generates

Not even close. But there are some who argue that the total cost of complying with the law may exceed the tax generated.

The IRS assessed $23.5 billion in net estate taxes in 2001, which compares with a total IRS budget of $8.7 billion.

But the estate-tax system's costs go well beyond the amount the IRS collects. People spend money on estate-planning services to reduce the tax's impact, for example, and on life-insurance policies to help their heirs pay any tax that's owed. Just filing an estate tax return can be expensive, since the form can be complicated and a high number of returns get audited, requiring professional help.

Alicia H. Munnell, a former Federal Reserve economist who served on President Clinton's Council of Economic Advisors, estimated that the federal estate-tax system generates $1 in compliance costs for every $1 in tax revenue that's raised.

The bottom line: It's pretty clear that collecting the estate tax is cost-effective for the government. Whether it's cost-effective for the rest of society is what's up for debate.

Myth No. 5: Repeal will actually increase the burden on heirs

The heirs of the biggest estates could face much higher capital-gains tax, but this isn't an issue that will affect most people. The reasons for this are complicated, so hang on while I explain.

Currently, the estate-tax system comes with a great bonus known as the "step up" in tax 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 parents paid $20,000 for stocks that were worth $200,000 on the day they died and bequeathed them to you. Without the step up, you'd have to pay capital-gains taxes on that $180,000 increase in value if you sold the investments. Thanks to the step-up, however, the stocks get a new basis of $200,000. If you sold them 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.

Now that you understand how the step-up works, you can see why people become upset when they hear that the step-up system is scheduled to be eliminated along with the estate tax.

Fortunately, there's a big exception.

The estate tax repeal law preserves the step-up for up to $1.3 million of assets you bequeath, plus an additional $3 million of assets given to a spouse. That means that up to $4.3 million of your estate will retain the step-up in basis. That should prevent the vast majority of heirs from having to worry about the issue.

Heirs of truly large estates, of course, would have to contend with losing the step-up, and the additional paperwork involved likely will be a nightmare. Without the step-up, they'll have to figure out what was paid for an asset years if not decades earlier, and try to keep track of any increases in basis along the way. (Reinvested dividends increase a tax basis, as do improvements to a house.)

The federal government actually tried this "carryover basis" system in the 1970s and eventually abandoned it as unworkable. Estate-tax attorneys predict the same thing may happen again.

The bottom line: Losing the step-up isn't an issue for the vast majority of heirs, but it could create problems for those who inherit from the largest estates. On the other hand, they will have the assets to pay people to sort out the problems.

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.