How Do I Pass on $5 Million to My Wife and Heirs?

Estate planning is a complicated thing, but here are some popular tax-saving strategies.
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I am over 85 years old and have an investment portfolio of $5 million-plus. My wife is of similar age, and I would like to provide for her during her lifetime. I would like to establish a family education vehicle with the majority of the funds going toward the higher education of my heirs. What is the best way to accomplish this?

-- Samuel Steven


This is a complicated area of estate planning, and you need to get yourself a good tax attorney. But we'll run through a few suggestions from our experts that you can discuss further with your adviser.

Before we dive in, you need to be aware that three different taxes are waiting to attack your money. Not only will you have estate and gift tax issues, but because your intent is to care for


generations -- not just your children -- you or your estate also will be subject to the generation-skipping transfer (GST) tax.

The GST tax is a flat 55% -- in addition to any other estate or gift taxes you may owe -- on the transfer of assets to beneficiaries who are more than one generation removed from yours. Basically, it's the tax that would have been owed if the money was transferred to your child, who then passed it on to your grandkids. The good news is that the first $1million in assets that you leave for future generations is GST tax-free.

To decrease the estate tax burden, you should split your assets between you and your wife, says Sandy Schlesinger, partner and chairman of the wills and estates department at

Kaye, Scholer, Fierman, Hays & Handler

, a New York law firm. That act alone will decrease your potential estate tax rate from 55% to 49%.

Now let's look at some strategies for minimizing the GST tax.

Dynasty Trust

A generation-skipping trust, a.k.a. dynasty trust, will allow you to take advantage of that $1 million GST tax exclusion while you're still alive, says David Bruckman, estate tax attorney at

Barry R. Eisenberg

, a White Plains, N.Y., law firm. Depending on the state where you set up the trust -- and you don't have to live in a state to set up a trust there -- the dynasty trust can go on forever.

Even better, since no one really owns this dynasty trust when you die, no one will pay estate tax on these assets, notes Bill Fleming, director of personal financial services for


. So it's a great device for protecting your descendants from those pesky taxes for a very long time.

Both you and your wife then can transfer $1 million to a dynasty trust and together create a $2 million dynasty trust without having to pay GST tax, says Bruckman. You will owe gift tax, though, when the dynasty trust is created. For 1999, you each have a $650,000 unified gift tax exemption. (This exemption will increase gradually to $1 million in 2006.) So you'll each owe gift tax on the balance of $350,000. But at least you've sheltered more than $2 million from GST tax, says Schlesinger.

Now all you need to do is appoint a trustee who will decide how much your beneficiaries will receive, says Schlesinger. So choose carefully. You don't want your trustee running off to Tahiti with your money.

If you put the whole $5 million in the trust, the additional $3 million would be hit with the 55% GST tax, and $3.7 million would be subject to gift tax, notes Bruckman. That means close to 60% of your money still would go to the federal government. And some states will tack on additional taxes. Fear not. I'll have more suggestions for the remaining $3 million shortly.

Charitable Lead Trust

If you're feeling philanthropic, a charitable lead trust might be something to consider, says Laura Peebles, director of estates, gifts and trusts at

Deloitte & Touche

in Washington.

A charitable lead trust (CLT) is an irrevocable trust in which income is paid to one or more charitable organizations for a fixed term. You can determine the length of the term and how much the charity gets. There are no minimums. (In contrast, a charitable remainder trust (CRT) must have a minimum 5% payout. See our previous

story on CRTs for more details.)

With a CLT, payments are made to charity for a fixed period of time, and any remaining money goes to your heirs estate-tax-free, says Peebles. Depending on how the CLT is set up, the estate can get a charitable deduction for those payments.

But you're betting that your trust is going to make more money than the percentage it's paying to charity. If it doesn't, your heirs could get a lot less. "So you're playing a numbers game," notes Schlesinger.

There are a few different types of CLTs, but a charitable lead unitrust (CLUT) will allow you to use your $1 million GST exemption.

One problem is that your heirs don't have access to the money while the trust is paying out to charity, says Schlesinger. And the payout period typically lasts from 10 to 20 years.

To rectify this issue, Peebles suggests creating at least two different CLUTs, staggering the charitable payout over short-term and long-term periods. You also may want to think about setting up a dynasty trust for the closer generations and a CLT for generations out in the future.

The FLP Option

Here are the basics to a family limited partnership, or FLP. The assets you give to the FLP are discounted -- up to 20%, potentially -- so you'll pay less gift tax up front. Then you can give pieces of the partnership to your heirs. Check out a previous

story for more details.

It's a viable idea, but the

Internal Revenue Service

is really cracking down on FLPs set up with marketable securities, says Peebles. So you do run the risk of an audit. But if you have the stomach for it, it can be an excellent device, says Fleming.

Start Giving It Away

So you've sheltered $2 million using a dynasty trust or a CLT. But what about the remaining $1.5 million each of you has?

Start giving it to your living heirs, recommends Bruckman. Each of you can give up to $10,000 annually gift-tax-free to anyone -- children, grandchildren, nieces, nephews, neighbors. As long as your individual gifts do not exceed $10,000, you will not owe gift tax.

And remember, while you're still alive, each of you can give an additional $10,000 gift-tax-free each year to whatever trust you establish, says Fleming.

Better yet, if you have heirs who already are in school, you can start paying for their tuition and expenses directly, and you won't pay tax on any of that money, notes Schlesinger. Or be sure to check out the new prepaid college tuition programs that are now available in some states, suggests Fleming. These programs may be a great way to shelter some income for your living heirs' college education. Some of the best

plans out there are from Massachusetts and New Hampshire, recommends Fleming. See this

previous Tax Forum for more on those programs.

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TSC Fund Forum aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.