A widow with $4 million in disposable assets came to Morgan Stanley wealth adviser Kathy Roeser recently with an urgent question: How to give away a sizable portion of her fortune as soon as possible?
With the "fiscal cliff" tax hikes on the way, the Chicago-area millionaire wanted to get the money out of her accounts by the end of the year, lest the federal government take the lion's share in the form of estate taxes.
The widow is not the only client of Roeser's concerned about her legacy. The $5 million exemption on estate taxes and lifetime gifts, law since 2009, is due to evaporate on Dec. 31, keeping tax lawyers and financial planners across the country busy.
With Congress and the White House focusing on talks about changes to the income and capital gains tax rates, relatively little has been said about the largest tax bump on the horizon: Without a consensus in Congress, the tax rate on estates and lifetime gifts will rise from 35 to 55 percent. That 20 point jump makes the potential rise in top income tax rates, from 35 percent to a threatened 39 percent, look like small potatoes.
More dramatic yet is the amount of money exposed to the tax: The current tax rates apply only to estates of more than $5 million. The end of the Bush tax cuts would reduce this exemption to $1 million. (Read More: American's Grades for Personal Finance Are Up — Barely)
Returning to a $1 million ceiling will mean the estate tax will touch many more people than it did when the Bush tax cuts were passed a decade ago. "An average American can have 1 or 2, or even 3 million dollars and not be wealthy," Roeser said.
Which is why Roeser and other financial planners believe that the estate tax and the lifetime gift exemption will be reset to a figure somewhere around $3 million — if for no less cynical reason than that's what the average congressmember is likely to have in investable assets.
That's still a lot of cash that the taxman can't touch, especially considering that, since spouses can each give away an amount up to the exemption without incurring taxes, the exemption for a married couple would be $6 million.
So before writing big Christmas checks to the kids, financial planners say, consider whether you really have enough money to worry about beating the "fiscal cliff" deadline. (Read More: 'Rare Good News' on Retirement Savings)
"It's a relatively small group of people who really need to worry now," said Michael S. Beriss, a former tax attorney who is now a financial planner with Ameriprise. To take full advantage of the current $5 million exemption, a married couple would have to have a spare $10 million in the bank. "If you give away $1 million today, you're not using your $5 million exemption," he said.
If you are ready to part with that kind of gift, planners say, by all means take advantage of a deal that's probably not going to get better. But not everyone has enough, or is old enough, to part with that much of their holdings, as Roeser reminded her widowed client. "I told her, 'You're 70 years old,'" said Roeser. "You don't know yet what your health-care costs are going to be.'"
That doesn't mean an older investor with investable assets and a home worth more than $3 million should do nothing, financial planners say. But it's not time to panic. Instead, it's time to do some planning.
For financial advisers, it should be noted, planning rarely seems to mean plotting how to sequester funds so the government can't get to it. "You may have other objectives than keeping your taxes down," said Beriss. "The real question you need to start with is: What are you trying to accomplish? What legacy do you want to leave?"
The legacy you envision should determine what kind of tax relief you choose. If you want to send your grandchildren to college, a 529 college savings account makes the most sense; if you want to support a cause, a charitable contribution may be the best way to protect your money. Trusts may be the smartest answer if your main objective is to make your kids' lives easier financially without leaving them with tax headaches themselves.
But a money-minded taxpayer may have as his or her goal simply to pay as small a percentage in tax as possible, to best preserve their cash legacy and keep the government's hand off it.
For these savers, even the worst case scenario — a return to the 55 percent tax on any amount greater than $1 million — is a salvageable situation. Estate tax, said Beriss, "is probably one of the holiest areas in tax code, and I don't mean it in the religious sense."
Behind that looming 55 percent gift or estate tax rate, IRS rules do seem to bend wildly to accommodate successful savers. Some instruments, like Grantor Retained Annuity Trusts, allow donors to transfer large amounts in ways that, on paper, don't exceed even the $13,500 that can be given away annually tax free.
These strategies tend to be complex, and can require some bets on how long you're going to live and how much profit a given asset is going to give off during the term of the trust. And only rarely will all the factors align so that absolutely nothing is owed to the government.
But to someone looking to shelter a hard-earned pile, they can seem a little like magic. "Giving something that is worth $1 million, but counts as less than $13,500," said Beriss, "that's the game."
The best of these maneuvers allow the taxpayer to push securities, cash or other assets out of their estate while still having access, at least in part, to the funds. This can be as simple as establishing a trust for one's spouse, but you may also put income-bearing properties in trust while still drawing on the proceeds.
Those proceeds, in turn, can be used to regain some of the funds that are donated. Beriss gave the example of a couple he's been advising since they were in the 40s. Early in the relationship they set aside a large amount for a charitable cause, while still taking profits on the donated amount. With some of those profits they took out a life insurance policy for roughly the amount they gave away.
On their deaths, the charity will get full possession of the couple's assets, while the life insurance policy will "pay back" their children the amount donated. The cost of the transaction — the premiums on the life policy — is pennies on the dollar.
Perhaps only a former tax lawyer would call arcane, multilevel tax strategies like this "entertaining," but he invites everyone looking to protect their fortune to share his confidence. The estate tax, Beriss said, "is not a tax on everyone, it's a tax on people who aren't paying attention."
—By CNBC.com's Paul O'Donnell
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