Don’t be lulled into a false sense of security by the fact that no estate or inheritance tax was due at your spouse’s death. As a general rule, no estate tax is imposed on the death of the first spouse, irrespective of the couple’s net worth.

Federal estate tax is built on the belief that the surviving spouse shouldn’t be burdened by estate tax. Instead, the estate tax is imposed at the death of the surviving spouse, that is, your death.

Since a good number of estates exceed $1,000,000, it is important that spouses plan together in order to fully utilize their respective Applicable Exclusion Amount. A properly planned estate for a married couple allows the couple to leave up to $2 million to the next generation free of Federal estate tax.

To accomplish this result, and gain the full benefit of each spouse’s Applicable Exclusion Amount, each spouse must prepare a revocable trust during his or her lifetime.

Each trust is drafted to allow the surviving spouse nearly full access to the trust assets during the surviving spouse’s lifetime, without having the trust assets included in the surviving spouse’s estate. As the Applicable Exclusion Amount goes up, you may not need to each have a trust. A joint trust may suffice.

However, you should be aware that changes in the estate tax law could reduce the Applicable Exclusion Amount in the future, or halt its increase. For those in second marriages who want to lock in their children’s inheritances, a two trust arrangement may be necessary. If you didn’t do any estate planning while your spouse was alive and your spouse left you more than the Applicable Exclusion Amount, you will have to play catch-up.

With your spouse gone, more sophisticated estate planning strategies will be required to reduce your estate tax liability. They include outright gifts to your children and grandchildren, use of irrevocable trusts, family limited liability companies, as well as a number of charitable options described below. These more sophisticated estate planning techniques are discussed in Chapter Ten: “Advanced Estate Planning.”

The following chart illustrates the scheduled increases in the Applicable Exclusion Amount between the years 2001 and 2010. If your estate exceeds these figures, or if your late spouse has a trust and your combined estate exceeds two times the figure shown for the year of your spouse’s death, estate tax will be owed at your death unless you take action.

The starting point in determining whether you exceed the taxable limit is to determine your “gross estate.” Items included in your gross estate include all property in which you have a beneficial interest at the time of death. The most obvious examples are cash, stocks, bonds, real estate, business interests, artwork and other personal tangible property. The following is a more complete list of property included in your gross estate:

The full face value of life insurance is included in your estate if you maintained any “incidents of ownership” over the policy, such as the right to change the beneficiary or borrow from the policy. To avoid estate tax, it may be advisable to own life insurance in an irrevocable trust (see “Irrevocable Trusts” in Chapter Ten). An irrevocable trust separates you from any incidents of ownership in the policy, thereby excluding the proceeds from your estate.

The full value of your IRA, 401(k) and other retirement plan is included in your estate. Distributions from these plans are also subject to income tax. The possibility of double taxation on retirement type assets requires special planning described in Chapter Six.

Debts and certain expenses are subtracted from your gross estate to arrive at your “adjusted gross estate.” Further deductions reduce the adjusted gross estate to arrive at the taxable estate. The tentative tax is computed using tables provided by the IRS. The tentative tax is then reduced by your unified credit.

The practical effect of all of these calculations and manipulations is that the first $1,000,000 (2002) of your taxable estate can be left to your beneficiaries tax-free. The estate tax begins to apply only to the extent your taxable estate exceeds $1,000,000 (in 2002). The following diagram illustrates the circuitous journey from the gross estate to the estate tax due.